Economics, Markets & Probablilities HAS MOVED -- econmkts.blogspot.com

FT Today: Paulson Says Crisis Sown by Imbalance

2009-01-02T10:45:00.002-05:00

Dog bites man headline to start.

Later in the article we get this:

“Excesses . . . built up for a long time, [with] investors looking for yield, mis-pricing risk,” he said. “It could take different forms. For some of the European banks it was eastern Europe. Spain and the UK were much more like the US with housing being the biggest bubble. With Japan it may be banks continuing to invest in equities.”

This argument – already advanced by a number of economists and largely endorsed by Federal Reserve chairman Ben Bernanke – suggests that the roots of the crisis do not simply lie in failures within the financial system.

It also implies that avoiding crises in future will require global macroeconomic co-operation as well as better financial regulation and risk-management.

Global macro cooperation? Please, stop, here is the problem -- policy makers are acting as if free trade means free floating exchange rates. Nothing can be further from the truth. Check the difference in dollar depreciation against the trade weighted index of major currencies and the dollar against the trade-weighted index of "Other Important Trading Partners", namely China, India, Korea, Russia, and Brazil.

If these countries insist on keeping their currencies effectively pegged to the dollar, the Fed has to be the central banker for everyone and, in a sense, punish them for that by raising interest in the U.S. when credit growth is accelerating too fast in the U.S., not inflation. Credit growth should be the main focus of policy, and the Fed should not worry about what bubble the credit growth is feeding. Because you know what? If the Fed keeps overall credit growth within bounds, there will be no asset bubble like the housing bubble and the high tech bubble in the 1990s. And if there is one, and the Fed has kept credit growth within bounds, well then caveat emptor.

Macropolicy today, fiscal and monetary, appears to be focused on getting the economy back to where it was by keeping the dollar at uncompetitive exchange rates, swapping collapsed private debt with public credit, and allowing huge surplus nations to sustain an effectively fixed currency. We will get recovery but nothing will have been accomplished and down the road the next collapse will be worse than this one. Recessions, depressions really, are about restructuring what went wrong not just getting the economy rolling again by putting humpty dumpty back together again. And the restructuring does not mean government taking control of the means of production and the distribution of capital. Re-regulation? Absolutely. But lets make all these financial institutions smaller not bigger. More on that in a different post.

As important as recovery is, it is equally important that recovery comes with free floating foreign exchange rates everywhere or a Fed reaction function keyed to credit growth rather than inflation. In truth, we should have both but credit restraint means no inflation. And let's stop worrying about the dollar as if it's strength reflects national manhood. The mercantilist countries, including Japan, don't seem particularly concerned that their currencies trade cheap why should ours? Okay, competitive devaluation is bad, absolute truth, but like I wrote above this is not about pegging exchanges, quite the opposite, it is about letting the market decide.

ZIRP & The Economy To Emerge

2008-12-18T08:22:00.002-05:00

In this attempt to get the economy going again a deep breath and a bit of thought seems in order. If the problem today is that consumers are too levered and in fact the economy is built on too much debt relative to national income, then the solution is to make debt cheaper? I know policymakers are trying to avoid depression, a valued goal, but it seems to me that they are now replacing consumer leverage with government leverage to get the economy back to the pre-recession level of economic activity. Considering all the talk about de-leveraging the U.S. economy because it is living beyond its means then shouldn't we be managing the shrinking of the economy through debt relief and loan modification to prevent wholesale asset sales rather than desparately trying to pump the air back into the balloon?

Perhaps a better solution to the current situation is to let the dollar fall. Now I know there are many of you who consider the currency's strength as an indicator of economic fortitude -- well this is an "old Europe" (to borrow a phrase) idea and certainly not an Asian one. And yes, competitive devaluation is overall destructive. My suggestion is not devaluation so much as letting the dollar fall to its fair price. Or, in other words, let the other currencies rise to theirs.

The whole story is a lot longer and this being a blog my promise is to keep it short. Looking at the markets, the rush for Treasurys continues unabated and the TIPs continue to price near term deflation. The so-called Treasury bubble is being created by two market forces of demand. First off, the Fed is buying. Second, and more important, no one wants to show anything in their portfolios other than Treasurys. Third, the rest of the world isn't doing so well and a lot of foreign buyers prefer the safety of U.S. Government securities. Once the year turns I would expect Treasurys to cheapen some but not a whole lot.

ZIRP!

2008-12-16T15:01:00.002-05:00

ZIRP reads more like one of those words in a Don Martin cartoon in Mad Magazine. You know, several panels of some funny looking guy eating all sorts of stuff and then in the last panel he puts his hand over his mouth and he goes "ZIRP!!!!"

I am not exactly sure what the cartoon character would have been eating but the Zero Interest Rate Policy, what ZIRP means here in the real world, means the Fed is going to digest a whole lot of Treasurys, Agencies, and Agency MBS. They also announced today that they are staying with this program for a long time to come. Inflation is no longer a concern. Amazing, isn't it, that this is the same group that in the spring was hinting at a rate hike at this point in the year because inflation was stubbornly high. Now it has decided to throw everything it got into the market.

To what effect? To punish investors for holding cash and government related securities. They are going to force the risk spread so wide that speculators first and investors second will begin to buy credit and return liquidity to a frozen market. The Fed is also saying to President Obama that they are standing aside and supporting, whole hog (so to speak), an enormous fiscal initiative. Which is obviously the second and necessary action if anyone is going to put up cash behind the belief that more credit will survive than go bust.

There is also the dollar play here, in other words a weaker one at first but, counter intuitively a much stronger one later on once growth takes hold and again global investors see this economy as the world's most important consumer.

Hate to throw cold water on the party, and while the Fed is doing the best it can under circumstances made worse by its gross misread of the economy when it was booming and when it started going bust. What got us into this mess is too rapid credit expansion, housing this time, high tech in the 90s, who knows what's next. All of it was fueled by an ever increasing inflow of foreign capital. The Fed, and here it is complicit in all this, chose to ignore the credit growth and the trade deficit believing the dollar would correct all of it. No such luck, the dollar is effectively fixed against our major trade surplus countries and so it was and is up to the Fed to do what a free exchange rate market would have done -- raise the real cost of capital in this country.

Enough history, looking forward policy today smacks a little bit like the hair of the dog on New Years Day. If the solution is to try and put the economy back together where it was, we will be here again. So a hair of the dog is okay considering the immediate alternative, but if we don't decide to stop drinking nothing will have been accomplished. And don't be surprised if the economy comes roaring back faster than expected. Remember those forecasting gloom were forecasting anything 12 months ago. There are other reasons, more solid ones than that, but I leave that for another post.

FOMC, GDP, ISM and YOU

2007-02-01T12:30:00.000-05:00

Not sure the iambic pentameter is working here, but hopefully the title catches your attention to the onslaught of data and the Fed. Stronger than expected GDP despite a 19% drop in residential investment, which took 1.2 percentage points off of growth, and an FOMC statement that moved the Fed from Dec's worrying about growth to confidence that the economy will grow -- while acknowledging that inflation has ebbed.

The market, in its infinite wisdom, rallied on the news, believing that the comments on inflation were setting the stage for an ease later this year. Since December, the market has moved its ease scenario out in time and down in its extent, but it is still betting on an ease beginning in August but definitely by December. Some of the market gurus, mostly wrong but never in doubt, are out there pitching the idea that softness is to come, 4th Q was a statistical anamoly, and look for an ease by July.

Markets want to read into to the statement what they want to believe. I believe something different. The Fed is telling us that the concerns they had about growth are past or at least passing, so they can be more confident in their forecast of continued moderate growth. As for inflation, they acknowledge the drop and they know it is energy related. They are also saying that resource use is tight and thus the risk for inflation remains.

So, tell me, if the Fed is confident about growth, which means greater utilization of resources, why does the market think the next move is an ease?

Two things to remember about this economy. First, it runs on credit and there is plenty available. Second, this economy is "adapt and grow". It has adapted to 5.25% funds, which is not restrictive, and so the economy is ready to grow. I believe that, the Fed believes that, the market savants that were convinced of a consumer implosion and recession last year -- don't.

Some Berry Good Thoughts . . . . So What Does Trigger The Fed

2007-01-24T09:56:00.000-05:00

In today's Bloomberg, John Berry writes that the Fed is going to do more of the same -- watch, wait, and note that the greater risk is inflation. Inflation is the risk because money is cheap and available and as long as credit can expand so too can the economy.

How easy is money? This was reported in this morning's Wall Street Journal:

The investing arms of Goldman Sachs Group Inc. and Morgan Stanley are quietly collaborating on a massive private-equity play for the oil-and-gas assets of utility company Dominion Resources Inc. -- a deal that could top out at $15 billion, people familiar with the matter said.

When $15 billion and play are in the same sentance, money and credit aren't being rationed.

Back to Berry.

He sets the stage by writing:

A few weeks ago, many financial analysts were predicting that slowing growth would prompt the Fed to adopt more neutral language at the Jan. 30-31 meeting in preparation for reducing the target in March or May.

That prediction was a major misreading of Fed thinking.

I should say so. But the street savants are often wrong but never in doubt. So where does Goldman, the erstwhile private equity player, stand? Again, from the Berry article:

On the other hand, economists at Goldman Sachs Group Inc. haven't abandoned their forecast of 75 basis points of rate reductions in 2007, beginning by midyear.

Perhaps their economists should have lunch with the private equity guys. Since investors risk the firm's capital, the proverbial money going where the mouth is, I side with the risk takers.

Here is the meat of the story, at least to me:

Their counterparts at Macroeconomic Advisers LLC, who don't expect any such slowing in job growth, said in their weekly forecast update on Jan. 19 that they ``expect the Federal Reserve to maintain the fed funds rate at 5.25 percent throughout 2007.'' . . . .

. . . . They went even further, adding: ``The next decision for the Fed will be whether to resume tightening or to remain on hold, given the economy's apparent resiliency and the upside inflation risks emanating from tight labor markets.''

That's not a decision that is going to be on the table next week, however.

A number of Fed officials have indicated in recent speeches that they are quite comfortable with the current 5.25 percent target . . . .

They become uncomfortable if the curve flattens enough such that the market prices in a tightening before the Fed does. This occurs if data begin to reveal what this blog has been saying -- too much money chasing too few opportunities. As long as the curve behaves, so too will the Fed.

In sum, the Fed now turns a bit from data dependancy to watching the watchers.

Silent Savants, Golden Moments

2007-01-22T13:31:00.000-05:00

Readers of this blog should be expressing a "what took so long" approach to the market sell-off rather than any suprise. The theme on this site has been questioning the market's obsessive pricing of Fed eases amidst expectations of a collapse in personal spending on the heels of collapsing home prices. The consistent answer to this view has been that the money creation process (that is bank lending) continues apace without any meaningful tightening of credit standards. Credit expansion trumps any concurrent slump in real estate pricing. Ask Sam Zell if there is a problem finding money to chase a mixed bag of properities. Continued lending by the banks is the reason why the inverted curve was indeed different this time around.

This is what Fed officials have been yapping about and why they remain vocally concerned about monetary inflation -- not the mere follow through of a commodity price spike. They have let us know that they anticipate some wage inflation in response to the multi-year trend that shifted earnings to the owners of capital and away from workers. The line between catch-up and inflation is for them to define.

While the FOMC waits and watches, you can expect the Fed to continue to talk a tougher game than they are playing. Market yields will continue to rise as ease expectations are unwound. Fed policy stays on the sidelines until the market approaches a positive curve that says the Fed is lagging economic events. Not something Bernanke would like to see. Until that time, mixed data and the unwind of those ridiculous expectations of Fed eases. Wonder what all the "street savants" will be saying after there is a no go at the end of the month.

Apologies for not writing since mid December. I have been taking time off and rearranging life priorities. My words of wisdom, balderdash to others, returns on a more regular basis in the next several weeks.

Bonds Spinning In Place

2006-12-15T16:12:00.000-05:00

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

2006-12-12T14:19:00.000-05:00

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

2006-12-12T12:21:00.000-05:00

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

2006-12-07T11:02:00.000-05:00

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

2006-12-04T13:44:00.000-05:00

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

2006-12-01T16:11:00.000-05:00

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.

Bernanke Bias Shifts To Neutral; First Step To An Ease

2006-11-28T17:57:00.000-05:00

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.

Fed and Market Dancing Together For The Holidays

2006-11-27T17:48:00.000-05:00

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.

Market Snaps Back Into Line

2006-11-17T16:56:00.000-05:00

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.

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

2006-11-16T16:21:00.000-05:00

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.

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

2006-11-14T15:01:00.000-05:00

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?

Market Wants Spring Break -- The Coming Week Will Tell

2006-11-10T16:57:00.000-05:00

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?

2006-11-10T12:37:00.000-05:00

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.

Dems Win, Fed Concern -- Rolling Back Globalization?

2006-11-08T12:54:00.000-05:00

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.

Fed Fixes Market Focus . . . . . .Again

2006-11-06T10:45:00.000-05:00

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.

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

2006-11-03T14:00:00.000-05:00

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).

Where Market Is Now -- The 170% Solution

2006-11-02T16:31:00.000-05:00

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.

Rubin In The Times, Betting Against The Dollar

2006-11-01T08:19:00.000-05:00

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.

Huh?

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?

International Capital Flows Alter U.S. Interest Rates

2006-10-31T18:05:00.000-05:00

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

2006-10-27T11:19:00.000-04:00

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

2006-10-25T17:46:00.000-04:00

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

2006-10-25T14:21:00.000-04:00

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

2006-10-25T12:00:00.000-04:00

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

2006-10-17T11:58:00.000-04:00

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

2006-10-16T17:31:00.000-04:00

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

2006-10-11T16:53:00.000-04:00

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?

2006-10-05T14:49:00.001-04:00

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.

Poole Q&A -- A Gift To Those Looking For An Ease

2006-09-29T16:22:00.000-04:00

In response to a question regarding the market's expectations of Fed policy next year, Poole gave an interesting resaponse. He noted that having the 10-year yielding 60 basis points under funds was not a tenable relationship for the long run. The trader, he added, is looking for less inflation and weaker growth and expecting the Fed to aggressively drop rates to a level below 4.65% (10-yr yield). Poole added that market forecasts, as honest and as good as they can be, do not have a good track record.

If inflation eases off, as the FOMC hopes, and real growth stays at or near potential, the Fed will not have to ease agressively and the 10-year yield would have to rise up to the funds rate or higher.

My italicized bold highlight informs us that IF the above scenario comes true, the FOMC is already set to give the market back the last 25 basis point hike.

In sum, if you think the Fed has done enough to quell inflation and not squash the economy, price in a 25bp cut for next year and short the 10-year. As for the timing of the move, considering that they want to see a solid pattern of data and are willing to wait until they get it, a March ease looks like the best bet.

Unless the unexpected occurs.

Neutral Is Neutral Is Neutral Until It Isn't

2006-09-29T11:36:00.000-04:00

As I wrote last night, Bill Poole, President of the St. Louis Fed, was going to feed us what the Fed has been feeding us: The funds rate is at neutral until the data prove that it isn't. Between the lines, there is a bit of a wink to the expectations that an ease next year is not out of the question but he also lays out the parameters;

If incoming economic indicators show that both output and inflation are rising above these forecasts, then in the absence of any other information we can expect that the FOMC will increase its target fed funds rate. On the other hand, if both output and inflation come in weaker than expected, we are unlikely to see further increases in the federal funds target; indeed, if economic weakness is pervasive enough the FOMC will at some point reduce the target funds rate.

The italics are mine.

Where is the wink to an ease next year?

If the economy comes in below the baseline forecast in coming quarters, the FOMC will have room to act as aggressively as required. I have no idea what scale of easing might be appropriate, for that will depend on the nature of the incoming information. Still, I believe forecasters should assign a relatively low probability to deep recession precisely because of the FOMC's demonstrated willingness to act aggressively as necessary.

So the Fed isn't expecting an upturn anytime soon, and while they expect the economy to slow to a less than 3% real growth path (the new non-inflationary trend path), if the wheels come off the proverbial bus they will be on it quickly -- there is no gradualism on the downside

As for market thinking, Poole notes:

The market's evaluation of the prospects for policy is revealed in the futures markets for federal funds and Eurodollar deposits. Current futures prices predict that the fed funds target is expected to begin moving down. . . . the market's expectation of future policy easing has been taking hold gradually since late June, say, in response to data on the real economy suggesting that real growth is slowing and inflation data suggesting that the worst may be over on that front.

Is the market right?

I want to underscore my earlier point about the limited accuracy of those forecasts. Some of the forecast misses have been pretty dramatic.

When the market has been wrong, it is generally when:

Both the FOMC and the markets were surprised by incoming information . . .

According to Fed studies, 70% of the difference between the Eurodollar futures market forecast for rates six months out and where rates acutally end up is explained by "no one saw it coming". Remember that when street people write with rock-solid confidence what is going to happen next and what the Fed will do about it.

The market overreacts to every data point, it has to. The street only gets paid when money changes hands, so getting everyone on edge about the importance of the next data release is part of the drill. Remember when it was the money supply data on Thursday night? Remember money supply?

Anyway, the Fed, being professional has no panic, professionals never do, which is why Poole says:

. . .it is rare that a single data report is decisive. 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. . . .

. . . .Policymakers piece together a picture of the economy from a variety of data, including anecdotal observations. When the various observations fit together to provide a coherent picture, the Fed can adjust the intended rate with some confidence.

As for my neutral is neutral until it isn't, Poole closes with:

That the policy setting is data dependent is a good sign. It means that policy is in a range than can be considered neutral that is, thought to be consistent with the Fed's longer-run policy objectives. . . . I believe that is just about exactly where we are today.

That may be where the Fed is, but not the market. As I wrote yesterday, Poole was going to disappoint the market by telling the grand poobahs of market opinion that he isn't ready to ease. It was predictable, as is the market's reaction. The 2-year Treasury is currently up 3.5 basis points on the day, 5's are up 4.3bps, and 10s are 3.7bps. The movement reflects the red Euros being down 3 to 4 basis points.

Even with this back up, the market is still pricing in 25% chance of an ease in Jan, around 25% to 30% in Mar and 40% in May. Pretty high odds considering Poole's comments. If you own the 2-year Treasury you own those odds. To give a sense of the risk, if the expectations went to 0% the 2-yr would back up near 60 basis points in yield.

I am predicting nothing but expecting anything. Odds of an ease are better than they are for a tightening, but the market is just too sure for me that the economy will need lower rates to avoid recession. May turn out to be true, and the Giants might win the Super Bowl, but how much do you want to bet on the outcome?

Poole Reconfirms Tomorrow What Market Refuses To Believe

2006-09-28T14:23:00.000-04:00

William Poole, the official unofficial spokesman for the FOMC speaks tomorrow at Middle Tenessee State University on U.S. Data Dependency. I am not sure what that means but I am sure that his talk or post-talk q&a will reiterate what the Fed has been saying since Bernanke's testimony in July -- neutral is neutral is neutral until it isn't and the data hasn't convinced the Fed otherwise.

Ever since the Fed met on September 20, the market has taken weaker activity around Philadelphia, softness in housing, and falling oil prices to mean that the Fed has a 15% shot of easing in December and almost certainty that the Fed eases sometime between now and May.

Poole tomorrow lets everyone know that the adults are back in charge. I can not see what data have been released to shift him from the view that rates are high enough to slow but not kill the economy, slow housing down to the pace where it should be given the level of income and employment growth, and therefore slowly ease inflation back down. He and the heads of the Dallas and Richmond Feds seem not to be as concerned with the slowdown as the market and they aren't the only ones.

Earlier this week, the real adults, Volcker and some of the other previous heads of the NY Fed had a discussion at the Women's Economic Round Table in New York.

Here, lifted from the Bloomberg article written by reporter Craig Torres, are some comments to focus on:

``I am a little bit more worried about inflation,'' said Volcker, 79, speaking at a discussion sponsored by the Women's Economic Round Table in New York yesterday. Gerald Corrigan, who served as New York Fed president from 1985 to 1993, said he shared Volcker's concerns.

While the inflation rate isn't ``high'' or ``running away,'' Volcker said, ``it is kind of creeping up, and I am impressed by the degree of pressure, if that is the right word -- psychological pressure, political pressure -- there is not to do anything about it.''

That is the what Poole and Bernanke and their compadres are concerned about -- the 3 year mountain of liquidity that Greenspan left them. They are not worried about housing and, as per Poole's comments on Bloomberg earlier this month, the drop in oil prices and bond yields are a stabilizer for the economy.

We shall see what he says just before the ISM number (Chicago is reported tomorrow, national on Monday) and employment in a week. He won't say they are ready to ease, only that aren't going to be tightening. That should be enough to disappoint.

Greenspan Puts ...... Again

2006-09-22T15:25:00.000-04:00

Rumor in the market today was that Greenspan told a hedge fund group that the Fed was not concerned about inflation and would inject liquidity into the system if the housing slump turned serious. Serious is in the eye of who is slumping (the next town, the neighbor, or me), and how much liquidity is enough to combat the slump. If it were serious, history has proven it would be more than a 25 bp drop.

Earlier this year, Greenspan gave a private talk that became public when he said the Fed would pause by June and then start easing about 6 months later to stem the weakness in housing.

Since that scenario has played out thus far, it is tough to ignore the rumored comments. The bid/offer for an ease by December is 14/24 after settling at 12 yesterday (Dec Fed funds digitals). The puts are still trading at 6.

How ready is Bernanke et al ready to jump in and ease to save people who took the housing boom a bit too seriously in terms of financial leverage?

During the 90s one of the mantras feeding the equity market was the perceived Greenspan put. That is, he would ease if the market faltered thereby removing downside risk. It is not clear to me that the current group sitting around the FOMC table every six weeks is of the mindset to create a free put on housing for real estate speculators. For one thing, jumping in so quickly puts a floor on inflation, which at least the Richmond Fed is still concerned about, and an ease now does nothing to solve the negative saving rate problem.

I am still of the mindset that rates are low enough, general economic momentum strong enough (now bouyed a bit by lower energy prices and lower yields) that the economy will exhibit enough growth to keep the Fed exactly where it is.

The upcoming employment data will again be important. Signs of weakness there would push the Fed towards an ease before year end. Another 125,000 number, 5.25% as far as the eye can see --- or at least till the following month's data.

Where We Are Now

2006-09-20T18:18:00.000-04:00

Fed statments be damned, the market remains undeterred in its quest to price in an ease next year. Spurred by softer data and ignoring the FOMC mantra to wait and watch, the traders and investors whose money flows determine fixed income prices pushed the probability of a 25bp ease by May of 2007 to near certainty. It seems that the whole course of the economy is now determined by manufacturing in the geography covered by the Philadelphia Fed. That might be true, and housing may be causing the economy to implode like a cheap tract house in Arizona, or it could be some wishful thinking on the part of market participants growing weary of negative carry.

Here below is the current state of probability affairs as lifted from the Bloomberg page set out by my partner, Stan Jonas, and used to help feed the trading strategies of our fund (this is not a solicitation, etc, etc, etc, merely full disclosure on my part)

The interesting point here is the Thur column which lays out the probablities implied by current pricing. The market is setting the odds at 1 in 3 of a cut in January, 1 in 5 in Mar and 2 in 5 by May. Cumulatively it adds to certainty by the May meeting.

As for expectations between now and year end, the no change view has gone from 66% to 82%. In that 18% betting on one move or another, it was 2 to 1 or 3 to 2 in favor of a tightening. Today it swung the other way and sits at 2 to 1 in favor of an ease: 12% to 6%. These numbers are garnered from the Fed funds digital options that trade on the CBOT.

It seems that once the Fed stops, the market just has to believe the next move is an ease. History favors this view, no doubt, but when everyone sees it, something else suprises. The only real indicator to me that the economy is slowing is the drop in oil to $60/bbl. Since I believed growth and not a contrived shortage was driving the price up, I have to remain consistent in my logic.

There is, however, another aspect to lower yields and reduced oil prices. They are in and of themselves a buffer to weaker growth. Knowing this, the Fed shows no inclination to micro-manage the economy by changing rates 25bp from neutral (where we are now). With Fed funds neither constraining or subsidizing growth in the aggregate, the Fed seems perfectly content to let the economy fluctuate around some trend path, pushed and pulled by shifts in relative prices. Let market participants draw strong trends from single data points, the Fed will have none of that in its own decision making process.

The Fed is out of the way, the bigger disappointment to the market will not be that they have tightened too much but that they did just enough.

Fed Tells Ip What They Have Fed The Market ...... and something more

2006-09-18T11:43:00.000-04:00

In the Saturday Wall Street Journal, Greg Ip, the erstwhile journalist and relayer of unattributed Fed thoughts to the masses (at least the masses that read the WSJ), wrote an interesting piece entitled "Outlook Divides The Fed, The Street" (I didn't bother with a link since you need a subscription to access the article online).

The article contained some points of interest. For one, there is this:

"Recent speeches by Fed officials suggest that while they are willing to stay on hold for now to see if their forecast of slowing growth and falling inflation comes about, they do not share the pessimism on growth, or the optimism on inflation, implicit in expectations of a rate cut by mid-2007."

In other words, don't expect anything in Sep or Oct or probably even Dec, since the Fed digests a flow of information before it decides to raise, lower, or hold. As of now, the information flow suggests that standing pat is the right stance.

The second message of this paragraph and one noted in this blog for at least the past month is -- "What is the market doing pricing an ease into next year?"

As Ip explains, the market is more pessimistic on growth than the Fed because they are more pessimistic on the impact of weak housing. Given the track record, it is better to bet on the Fed in a stakes race than on the "street". If you own a two-year Treasury, understand that the underlying bet is the flip -- against the Fed and with the street analysts/economists/etc. These street people are the same ones who told us last year that 3.5% was the neutral top and anything higher risks doom, destruction, and depression. The market, by the way, was forecasting a decline in the funds rate in 2006. As Casey Stengel used to say, "you can look it up"

Another thought is that while the bond market is trading at low yields reflective of the expectation for a Fed ease next year the stock market is doing very well, credit spreads are tight, and lending standards are easy. This combination is a recipe for expansion not contraction. Your money, your bet, your risk.

This line in the Ip article strikes me the most:

"Moreover, the Fed seems to think the economy's potential growth -- what it can achieve without straining business and labor capacity and thus fueling inflation -- is lower than many on Wall Street think."

When did this happen?

The whole rationale behind the Greenspan policy in the mid 90s and the "new economy" paradigm, etc., etc., etc., was that high productivity, global sourcing, technological advances, and capital deepening meant that the economy could handle a much faster rate of growth and resource utilization without triggering inflation. Now it can't?

Some explanation is in order.

Is the explanation that the good fortune on inflation in the 90s was as much because of external forces, such as bad policy holding down Japan, as it was because of intended domestic policy (monetary and fiscal) and policy with unintended effects (the peace dividend)? And if outside forces effected domestic inflation to the extent that the Fed went from new paradigm to old inside of one business cycle, how can the Fed run a long-term policy based on inflation targetting when inflation is not totally the result of our doing?

These are the more important questions than what the Fed does this week and what it says after its done nothing.

Fed Tells Berry That It Wants To Tell Us More.......Or Less

2006-09-14T14:58:00.000-04:00

Odd logic this is, for the Fed to go through one of its journalists to let us know that they want to "cast more light on the central bank's inner workings". They could've just told us directly, but I guess old habits are hard to break.

The article written by John Berry, on Bloomberg News on Thursday Sep 14, starts out with:

Federal Reserve officials want to cast more light on the central bank's inner workings to give the public a better understanding of what they are doing and why. The big hurdle is figuring out how to go about it.

The article goes on to tell us:

The most important consideration, according to the minutes, was how to convey the FOMC's goals and Fed appraisals of where the economy is headed.
Fed Chairman Ben S. Bernanke has some ideas about how to lift the veil a bit more: He wants the committee to adopt a formal inflation goal and publish more frequent economic forecasts that would show the expected path for inflation.

This isn't about clarity, this is about keeping everyone's eyes on the horizon instead of their driving. They can ask us to do that because they have us convinced that they are the designated driver of choice.

As for what horizon we are driving towards, the article offers this (bold is mine):

More recently, the committee has indicated a willingness to take as long as two years to bring core inflation back down to 2 percent from the 2.4 percent increase for the 12 months ended in July.

This is all about about inflation targetting. An idea that, like many in economics, is wonderful in theory but somewhat problematic in the real world. Everyone understands that a low, stable, and predictable inflation rate induces business confidence to invest which, in turn, raises employment levels (the other one of the Fed's dual goals). This logic, right or wrong, is required because one policy lever can only work on one policy objective. Since the Fed works through the financial side of the economy, inflation has to be the target.

Take a look at growth, inflation, and the funds rate:

It easy to see that in the mid 90s similar real growth created far less inflation than we have today. Then, the Federal funds rate was significantly higher on its own and in relation to nominal GDP growth (add GDP and deflator). One could conclude that there is an overhang of monetary expansion still in the system since it was only this year that the funds rate got to the mid 90s level. Yet Fed officials talk about the tightening in the pipeline, as if rates have risen to some confiscatory level. My guess is that they are really talking about engineering a soft landing for housing now that the housing industry's rate subsidy is gone.

But the end of a subsidy doesn't mean rates are too high. There is nothing about the level of rates today to suggest anything other than that rates have, after two years, finally reached neutral. When did the economy become so rate sensitive that this level of rates risks recession? The market, in its infinite wisom, seems to think so. I think otherwise.

As for inflation and setting a target, the higher inflation today suggests a higher funds rate than prevailed in the mid 90s. Or, perhaps the funds rate was too high in the 90s, hence the idea that a 5+% rate will bring down current inflation. Or perhaps the answer is that the good inflation data of the 90s reflected the pace of growth of the G-10 nations -- most notably Japan. Those growth levels, lower then than now, directly effected commodity prices, namely oil. Therefore, then the Fed could afford to allow the economy to run at full steam without raising rates. The upshot is how do you pick a relevant inflation rate to target. Economics is one thing, policy is another.

Yellen Back In The Poole; Mishkin's Paper Is The New Playbook

2006-09-07T16:48:00.000-04:00

Janet Yellen, President of the Federal Reserve Bank of San Francisco, gave a speech in Boise (she must be walking back from Jackson Hole)to a Community Outreach Luncheon on "Prospects for the U.S. Economy" Just as at the end of July, Yellen essentially parroted Bill Poole's (President of the St. Louis Fed) recent speech and his comments the other day on the Bloomberg. In sum, the Fed has reached the neutral rate we were guessing about once the funds rate began its climb from 1% in 1/4 point steps beginning with the June 04 meeting. With Yellen having spoken the same speech as Poole, both sides of the FOMC debate (the sides that matter) are on the same page. Neutral is neutral is neutral until the data prove it isn't.

Markets, being creatures of habit, are having a difficult time with neutral because they can't get used to the Fed making us guess the next move rather than telegraphing it.

To understand what the Fed is communicating, leaving aside whether 5.25% is right or wrong, Prof. Frederick S. Mishkin (now a FOMC member) essentially wrote the "playbook" in his paper "Can Central Bank Transparency Go Too Far". Parsing the abstract alone underscores my point.

As for what the Fed was doing when it was telegraphing the long, steady climb from extraordinary ease to neutrality:

Transparency is beneficial only when it serves to simplify communication with the public and helps generate support for central banks to conduct monetary policy optimally with an appropriate focus on long-run objectives.

He later adds:

Transparency can indeed go too far. However, central banks can improve transparency in discussing that they do care about reducing output fluctuations ... by emphasizing that monetary policy will be just as vigilant in preventing inflation from falling too low as it is from preventing it from being too high.... central banks can show that they do care about output fluctuations.

Compare this with the end of Yellen's speech today:

....while giving due consideration to the risks to economic activity....

..... policy must be responsive to the data as it emerges..... any additional firming should depend on how emerging developments affect the economic outlook....

The bottom line is this....... By pausing, we allowed ourselves more time to observe the data and more time to gauge how much, if any, additional firming is needed to pursue our dual mandate.

Getting back to Mishkin's paper:

These steps to improve transparency will increase support for the central bank's policies and independence, but avoid a focus on the short run that could interfere with the ability of the central bank to do its job effectively.

Yesterday, Poole told us that future policy moves will be determined by future data that is unknown and unpredictable. Hence, it is impossible to know what the Fed will be doing next month let alone next year. Of course, he adds, ala the Mishkin prescription, that he will keep the funds rate high enough to keep inflation down.

Neutral is neutral is neutral until the data prove that it isn't.

The market still has a tiny bias that the Fed might tighten one more time this year. The December Fed funds digital options indicate a 33% chance that the Fed does something between now and the December 12 meeting with a bias (21 to 12) that the move is a hike in rates. Compared to a few trading days ago, the expectation that the Fed does nothing has risen from 60% to 67%. When the view was 60% the mix of the remaining 40% was dead even.

Looking at the market's pricing for next year, the leaning is still towards an ease, although less so. My guess is that the market is now at 40% certainty of a 100bp cumulative drop next year compared to 50% at the end of last week. The market is setting the odds of a bit better than 1 in 4 that the first drop occurs at the January 2007 meeting.

From my rudimentary calculations, if the market expectations shifted to 0% chance of any Fed actions from today on out, the yield on 2-year Treasurys would rise around 25 basis points. On the other hand, if the market prices 0% this year and gets a bit more aggressive on the ease picture for next year, the 2-year drops around 10 basis points in yield.

The risk is yours to figure based on your view of the world. But remember, the people running the world (the market world) are telling you that they don't know what is going to happen so they don't know what they are going to do. Pricing anything other than "no move" is just a guess.

Poole On Bloomberg Tells Us All We Need To Know

2006-09-05T15:37:00.000-04:00

Poole had a q & a on Bloomberg this morning, and if anyone was uncertain as to where the Fed is and, more important, where it is going to be, he ended all speculation.

Here are some of my highlights from his comments --

On housing and its impact on growth: There are always worry warts, on both sides. Housing is slowing. Fed expected it to slow. Fed wanted it to slow. Slowdown may be a bit more than expected but commercial construction is up and hires the same resources (labor and material) residential construction uses. Further, the employment data indicate an economy growing at potential. No reason to expect cascading weakness from housing to create a much slower economy.

Yield curve and market's forecast of Fed action: Negative curve can be viewed as anticipation of a Fed ease but lower bond yields are also a built-in stabilizer to the economy that helps housing and keeps the economy from getting weaker. As a predictor, curve has given false signals and the bond market is trying to predict policy action that will be driven by new information that, by definition, is random and unpredictable.

A key comment: Looking at a 6 month horizon, 70% of the fluctuation in the bond market comes from new, unanticipated information. New information is random, unpredictable, and policy is driven by new information.......

Summing up: Policy is as tight as it has to be and the economy is growing at potential. As such, inflation should moderate over time and the Fed can be patient and wait months even quarters, no reason to create a disturbance in the economy by changing the funds rate. Fed policy will be driven by new information that is viewed in context with all other information. New information is random and unpredictable. By extension, what the Fed will do in the future is unpredictable.

Meaning: Fed is done. Next policy move can be either way, although there is bias in the logic to presume that the suprise to cause the Fed to act will be indications of a weak economy. As for the timing of the next move --it might be a while, there is no hurry to do anything.

Employment Takes The Fed Out, Business Week Takes Out Housing

2006-09-01T13:56:00.000-04:00

After dipping a bit in April and May, nonfarm employment added 128,000 seasonally adjusted workers. As key as this number is, remember Poole told us yesterday that it isn't one data point, June was revised up from 124,000 to 134,000 and July was raised to 121,000 from 113,000. August's employment number is also the three and the six month average. Right on target, as the Fed told us in early June, for trend growth at this level of resource utilization. A non-inflationary growth path if there ever was one.

The impact of this number means that Sep is officially off the boards (as if there ever should have been any doubt) and now Oct is wiped off as well. My reasoning is that the Fed, once again as Poole told us, reacts to strings of data that paint a story in line with other data. The data the Fed is most sensitive to is employment -- after all, that is one of their two missions. No matter what the Sep data show in October, it is not going to cause the Fed to react. I leave out, of course, the unforeseen random event that could crater the economy.

In the past few trading days, however, the market has been pushing up the odds of an ease. After the data came out, there was a brief selloff that was effectively pulling those odds back to zero. But neither is the market to be daunted by one data point. So when the 7% drop in pending homes drop (month-over-month) came out, the market rallied the ease scenario back into the price structure for 2007. In creating this outlook for weak growth based on weak housing, the market obviously discounts the 17,000 construction jobs added in August v 5,000 in July and after shedding 6,000 in May and June combined. Perhaps Poole was right in his q&a yesterday when he noted that other areas of construction, namely nonresidential, was fine and there is an overblown importance given to housing.

Based on inter-month spreads in the Federal funds futures contracts, the market is pricing in an approximate 30% chance of the Fed easing in January. From now to year end, the market is giving about a 60% chance that the Fed does nothing and thus a 40% chance, equally divided, that the Fed does something. Right where the Fed wants us -- smack in the middle recognizing the equal probability of an ease or a tightening.

When the Fed-speakers address current market expectations, I believe they are talking about the ease priced in for next year. By my calculations, the market is giving 50/50 odds that the Fed will cumulatively drop the funds rate 100 basis points in 2007. The market has kept this view even though employment is rising apace, income is up, gas prices are down, and the dollar is weaker (helps capex. The only reason I can surmise is the singular focus on housing. Not just the knock-off effect of reduced construction and rising inventories of unsold homes, but also the ticking time bomb of the impact of rising rates and falling home prices on various exotic mortgages.

This week Business Week has the following cover story:

Now we can rest assured that everything is fine. Will all due respect to the hard working folk at Business Week, their covers have been a contratrend indicator for years.

I still hold that the biggest risk in the fixed-income market is the stubborn view that the economy will slow and the Fed will ease. Perhaps with the end of summer, cooler temperatures will bring about more rational reasoning.

Employment, Poole, and the Odds of A Move

2006-08-31T14:28:00.000-04:00

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

2006-08-27T01:31:00.000-04:00

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

2006-08-25T10:26:00.000-04:00

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

2006-08-17T18:35:00.000-04:00

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

2006-08-16T19:00:00.000-04:00

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

2006-08-09T16:05:00.000-04:00

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,

2006-08-08T14:32:00.000-04:00

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

2006-08-07T18:37:00.000-04:00

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

2006-08-02T12:39:00.000-04:00

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.

Poole Speaks/Yellen Confirms/The Game Is Afoot

2006-07-31T12:39:00.000-04:00

Poole has spoken -- he is officially 50/50 on whether the Fed should go or not. The remarks were made today, post a speech he made "Chinese Growth: A Source of U.S. Export Opportunities" in Lousiville, Ky. Poole pointed out that more incoming data between now and August 8 will be critical, such as Friday's employment report. Yellen gave a speech today at the Golden Gate University Speakers series and said the same -- 50/50. The game of managing the markets expectations as evidenced by the Fed funds futures market has begun.

The Fedspeak may be 50/50 , but the market remains at only a 26% likelihood they tighten in August and then nothing until they ease next year. The bond market, in its infinite wisdom and led by their chief spokesman Bill Gross, has voted that the bear market in bonds is over for this cycle. To give Bill his due, not that he needs it from me, he is a longer term bear for many of the same reasons I am -- the need to inflate is greater than not (opposite of 1979).

Strange, however, that the market is more certain than the Fed that August is a no-go, at least by virtue of public statements. If the Fed wants to move the market back to 50/50 look for an Ip article today or tomorrow.

To put the current market in expectations in some context let me trace today's comments from Yellen and Poole back to Bernanke's testimony on July 19, when he stated:

"In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. . . . . effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline." Finally, as I have noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized.

At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand."

Which facts? Employment and CPI data? At this stage of the cycle greater import is given to anecdotal information than not -- the Beige Book. The reason to rely on anecdotal data was specifically laid out in Poole's speech at a Bank Of Korea Conference on June 16, "The Role of Anecdotal Information in Monetary Policy" If you want the academic model for how the FOMC should be analyzing the current environment read "Real-time Model Uncertainty in the United States: The Fed from 1996-2003" by Tetlow and Ironside.

The Fed is looking at the entrails of the data coming in. The Fed is making lots of phone calls to the business community. They are trying to figure out whether the economy is at the point where they should trust their forecast and believe the moderation story (see my last blog "White Kunckle Time for Bernanke").

There is another item that helps put today's comments into some context. Prof. Mishkin's paper "Can Central Bank Transparency Go Too Far?". If you can't wait for the movie, the essence of the paper is that at some stage policy is more effective if policy moves are unknown in the short-term against the market's understanding what the longer-term goal is, assuming that the central bank has established credibility -- through previous communication and action. Prof. Mishkin is now on the FOMC. The move from transparent communication to opaque has begun.

In sum, the market thinks it sees through the opaque policy statements to believe that the data and building anecdotal evidence (best shown in the beige book) mean that August is a no go. If the Fed does go, the markets will probably rally anyway, believing that they went too far. This is one case where I believe the market is right in anticipating a no-go. My impression is that the Fed is much less certain than the market than an ease next year is baked in the cake. Perhaps that is the message they are trying to get across.

White Knuckle Time For Bernanke?

2006-07-20T12:57:00.000-04:00

Every trader and investor that has been around for a while knows "white knuckle" time. For the uninitiated, white knuckle time comes when the market is against you more than anticipated, margin calls are coming and you have to decide whether you have the resolve to stick with your position or bail. White knuckle time. All the quant models in the world can't help, a combination of judgement and confidence is the hallmark of survivors.

Economists who earn their keep by the value of their opinions have their white knuckle time -- when inflection or turning points are forecast. Such forecasts, built on longer-term economic fundamentals, inevitably come up against a run of data suggesting the contrary. Data lag current conditions, everyone knows that, but sometimes the run is right and the forecast is wrong. Judgment and confidence are tested, stick with the view or do what Keynes did: "When I get new information I change my mind, what do you do?"

Bernanke's forecasts carry a bit more impact. His recent testimony suggests, at least to me, that his white knuckle time may be on the horizon if not already here. At some point, in the face of continued bad inflation news, he will stop tightening with the confidence that the Fed forecast for moderate growth based on weaker housing, high energy costs, and higher interest rates (finally!) will be right. Lack confidence in the outlook and keep tightening, risk recession. If he stops and the forecast is wrong, risk worsening inflation. White knuckle time. There is one thing in their forecast we don't know, where they set the funds rate. Is the next tightening in? Is the model using an endogenous equation for fund? If so, what level is the model coming up with.

Greenspan had his share of white knuckle periods and one fairly analagous to this one was 1995, when he stopped easing before growth turned back up. Then the economy accelerated and market calls for tightening through 1996 were met by a "no change in the funds rate" policy. Greenspan's response to the market was his new paradigm manifesto -- the economy can handle alot more growth without inflation because of technology and globalization. He was right. The market was wrong. How come that paradigm doesn't exist now? Topic for another blog.

Getting back to the current situation, the Fed always had a stated preference to err on the "too tight" side, believing it is easier to reverse downturns than inflation expectations. But Fed Chairmen, especially new ones, are also not immune to public opinion. I doubt Bernanke wants his first major accomplishment to be a recession.

He does, however, have a problem. Greenspan and his global counterparts left a mountain of liquidity that has been moving its inflation impact from financial assets to real ones.

His testimony gave us some Eco 101 -- the lead/lag relationship between interest rates (that is monetary policy) and the economy. He gave us that anecdotal information is more important than published data at turning points and surveys of inflation expectations are critical to read and contain. He didn't give us an explicit roadmap. That isn't necessary, from my vantage point, since the open mouth policy was meant to help the Fed wean the economy off of extraordinary accomodation and onto more realistic levels for the cost of credit. Now, as new FOMC member Mishkin has written, sometimes it is better for the Fed to say less.

In the end, Bernanke gave us a punt. Market reaction, one more tightening, most likely August, and then done. Of course the market did what a punt is supposed to do -- confuse (see Mishkin). On Friday, the market went from certain go to certain no go. A dizzying spin. The coming week suggests more of the same.

What will he do at the August meeting? I think he skips and hangs on with white knuckles, hoping he didn't stop too soon or go too far.

Where The Bond Market Is, It Can't Be On August 8, 2:15pm

2006-07-18T15:22:00.000-04:00

The reaction to today's PPI data, along with recalibrated expectations for tomorrow's events, put back a reasonable sense of fear into investors that the Fed will raise rates another 25 basis points at the August meeting. The market went from a less than 50/50 chance of a tightening to a 60% chance of a 25bp hike. The congnoscente now wait for black or white smoke to rise from Capitol Hill at 10:01AM, with the outcome somehow dependant on the CPI data released that morning. Will core be .3 or higher? A lot of silliness to believe that Fed action in August depends on one data point or that Bernanke will do anything more than keep his options open while expressing optimism for the economy (good for stocks) and vigilance on inflation (good for bonds). More on this at the end of this posting.

The current pricing of the market embeds a pattern of expectations for Fed action that, when the time comes, the market won't be there. Fed funds and Eurodollar futures and their options are priced to an expectation that the Fed is August And Done. If you believe that to be the case and buy the two-year all you earn is the coupon -- nothing more when you bet with the forwards.

The August and Done scenario, however, can only be true retrospectively. Prospectively, if the Fed goes in August what are the odds that investors, advised by the same cognoscente who, last summer, were predicting Fed eases this summer, will hold September expectations to 0? Most likely we go to 50/50 at first, 25% at best if you are bullish.

Understand, however, that if the Fed goes in August and then the market prices in a 60% probability of going in September, 25% in Oct, 10% in Dec and 5% in Jan, the two-year goes up 22 basis points in yield (my guesstimate, certaintly no guarantee). If the market, after the Fed goes in August, expects a 6% funds rate, my guess is that the two-year moves 37 basis points higher. All the other maturities move the same in yield terms, more or less.

The only way to get a rally in the market is if the Fed SKIPS August and the market follows up with an expectation for no more tightenings, or perhaps even the potential for an ease. In that case, the market can rally anywhere from 15 to 25 basis points or more if the ease expectations creep into this calendar year.

The upshot is that if you own a two-year Treasury and want cap gains in the near term, your investment is a bet that the Fed skips August. If that makes you uncomfortable, change your investment.

I am not predicting what the Fed will do, I am just trying to define the risk.

Personally, 60/40 is about right for August and I really do not expect Bernanke to give us much more guidance outside of that. For those of you thinking he might do a rewrite after the CPI number (actually he will have it tonight, as will the White House) remember this -- the Fed understands the lead/lag relationship between inflation and growth. The worst inflation year in a business cycle is usually the first year of recession. What will, as a consequence, drive the Fed to act or not act is not the CPI data released tomorrow morning per se, but their internal forecast of the economy. IF they are confident that 5.25% is enough because the past tightenings plus high energy costs pull nominal GDP growth under 6%, then they are done. If not, they aren't. And if you own Treasurys, you've bet they're done.

Inflation, The Fed, and The Market: Where lies rationality?

2006-07-17T09:46:00.000-04:00

7/17/06 8:14pm (Dow Jones) "Inflation is not the number-one threat to the US economy right now as much as the Fed's over-reaction to it," Merrill says. "The Fed's jawboning in recent months has been so intense that even with the turbulence in the markets, and the fact that two of every three economic indicators have come in below expected, that the futures market is still pricing in more than 50-50 probability that the Fed tightens yet again on 8 August," firm says. It's a "grim reality" that it probably comes down to Wednesday's June CPI number -- if it's 0.3% or higher month-over-month, the Fed has little choice but to tighten further, Merrill adds. (JHS)

Now that Merrill has said it, it must be true. Anyone who has been reading this blog knows that it has been my contention that the Fed will likely stop short of the number where money truly becomes expensive (6% or higher, based on nominal GDP growth) and keep some inflation bias in the system. The summation of what the Fed wants is a seamless turnover of the growth engine from housing to capital spending. No one, I repeat, NO ONE wants a recession.

Why the swap? Housing kept the economy going while business repaired balance sheets from the asset deflation that marked the past recession. Consumers didn't have to do as much since many more have homes as their number one asset as opposed to stocks. Capital spending improves the quality of growth over the long term. What helps spending today? Confidence in continued growth, weaker but not a collapsing dollar, cost of money below the expected return on physical capital to name a few.....and even a little inflation. Higher energy costs, as I have noted before, are also a boost to spending. In fact, now that everyone understands that $70 oil is here to stay and higher prices are likely, lots of opportunity for capital spending -- on the energy production and energy conservation sides of the broader equation.

Today we got industrial production and capacity utilization, this is from Bloomberg News as reported by Joe Richter

"Industrial production increased in the second quarter at an annual rate of 6.6 percent, the fastest since the final three months of 1997 and a sign corporate investment is sustaining growth as consumer spending slows. The inflation threat posed by higher energy costs and factories approaching production limits may prompt Fed policy makers to bump up interest rates again.

``Anything related to capital spending is strong and expected to stay strong,'' said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. The rise in capacity utilization ``is one more indication that the Fed can't take its eye off of inflation. The Fed probably isn't finished raising rates.''"

Later in the article, Joe writes:

"Factories added 15,000 workers in June after shedding 8,000 in May, the Labor Department said July 7. The manufacturing workweek rose to 41.3 hours in June, the most since January 2000, from 41.2 hours in May.

A report from the Institute for Supply Management earlier this month showed that while manufacturing growth slowed in June, new orders rose to the highest in three months."

The swap is underway and so the Fed is writing and saying and looking for a place to stop and watch and wait. Markets have moved from certainty to uncertainty regarding the Fed in August. Thats okay, what still amazes is that EVERYONE assumes that the Fed will be easing next year (how else would you get the inverted curve from 2s to 5s).

Interestingly, if you play around with the Sep/Oct futures spread and its reaction to various events it could hedge up your downside risk in any Treasury -- even 30 year Zeros. Imagine that, if you run a pension fund you can buy an asset at 23 that is guaranteed to go to 100 in 30 years (400% return over 30 years?) with no downside risk with a costless hedge. Everyone still matching pension liabilities with equities?

Bernanke Opts For Mishkin For FOMC -- A Turn For Monetary Policy?

2006-06-30T14:45:00.000-04:00

I wasn't planning on writing anything today, but the Mishkin appointment has made me do it. He is obviously academically qualified and of the same inflation targetting mindset, this is beyond debate. What is interesting about the appointment, and it is a good assumption that Bernanke wanted him for the FOMC, is his paper "Can Central Bank Transparency Go Too Far".

Here is Mishkin in his own words in the abstract:

"This paper argues that some suggestions for increased transparency, particularly a central bank announcement of its objective function or projections of the path of the policy interest rate, will complicate the communication process and weaken support for a central bank focus on long-run objectives."

Have a good holiday weekend, more on this next week.

What The Fed Said

2006-06-29T15:56:00.000-04:00

Parsing through an FOMC statement is always fun, this time it is also interesting. The Fed has moved from forward-looking statements on inflation, resource utilization, and the moderation in growth, to the here and now: Inflation is up, resource utilization is high and growth has moderated. Last month they wanted to emphasize that future Fed action would depend on data, this month the FOMC dropped the word “emphasis”. My guess is that they believe the market finally understands that a pause is not necessarily forever or tacit admission that they went too far. As far as the shift to the present in terms of describing the economic landscape, the FOMC is telling us that if growth is to pull down or at least temper inflation expectations it is going to occur in the next several months. If not, the doves lose and more tightenings are sure to come.

So now it is “wait till August” and the data that are collected between now and then. But if you read the Poole speech to the Korean Bankers and a recent Fed paper, “Do Macro Variables, Asset Markets, or Surveys Forecast Inflation Better?” (Andrew Ang, Geert Bekaert, and Min Wei) one recognizes that what Bernanke et al will be watching are the surveys and the anecdotal and not necessarily the published data.

In sum, the odds are 50/50 for August, though the market has, in its infinite wisdom, has decided that after August the Fed is done and the eases begin a year from now. What the Fed wants is to recapture its position in the mid 90s – no activity for a long period of time. Rates are probably too low for that, but they are balanced against high, and here to stay high, energy prices. The mix is interesting, the cross-currents are many, but there is one thing we can be sure of -- if the market starts pricing in the odds of Fed activity that is well off from where the Fed thinks they should be, they will let us know.

Bernanke Berry Blurbs -- Whats a Chairman to do?

2006-06-27T17:36:00.000-04:00

A brief note coming into the Thursday FOMC meeting, or really the statement. The Berry article today was, I believe, an attempt to tell the market that if we stop, it doesn't mean we can't start again and please, please, please understand that it doesn't mean we are soft on inflation. So lets keep rates up and not let the curve invert (which really means the market betting on an ease next year).

A halt does mean that its time to step back and see how the patient is doing. At the broad level, all this makes sense. At first, the economy needed some hand holding as the Fed started to lift rates from 1% to where we are now. The recovery seemed fragile -- animal spirits were burdened by too much debt leveraged off of assets that deflated. Now that we are several years into recovery and rates are about 150 points below nominal growth, there can't be a road map for whats next -- the economic outlook is uncertain. There can be an understanding that the Fed is resolute in allowing real growth but squashing activity that smells of inflation expectations, hence the Berry article. We all know that investors don't like uncertainty and brokers love it, so the Fed clearly helps investors between the meetings by letting us all know how they are viewing the data and its influence on policy.

What Bernanke wants as the end to this current game is credibility and for rates to level out so they and the economy can behave more like 1996/97/98. It was then that Greenspan found the new economy, we found goldilocks, the Fed raised rates 25bp once in that period -- at the Mar 97 meeting. During that whole time, Greenspan was running counter to the wise wall street wizards who were proclaiming that the economy was too hot, etc. for rates to stay that low and keep inflation down. Greenspan was right, the wizards were wrong. The policy did, however, create its excesses, culminating in the LTCM debacle that caused the sharp drop in rates in Sep 98.

Enough history, bottom line is that we are going to live in this uncertainty for a while. Although I think he his stopping too soon to quash inflation, it still isn't wrong for Bernanke to hold at 5.25% and wait and see. By the way, for those convinced of a pause in August and a go in Sep -- if you know the Fed is going to go in Sep, why wouldn't they just go now, or is it that your forecast is better than the Fed's? Given the track record of the street's forecasts vs the Fed, I'll bet on the Fed.

The Transparency Of A 50 Basis Point Move

2006-06-21T16:17:00.000-04:00

We are beginning to see the distant rumblings of 50bp tightening suprises from "The Street". At one point there was even a near 10% probability priced into the June Fed funds contract. As I noted in a previous post, talk of a "shock 50" was bound to happpen. Such a move, however, is unlikely to occur and unlikely to get the Fed what it wants -- slower growth. Why not? In the first instance, in reaction the long end rallies and so too might the stock market, anticipating that the Fed is done and may soon have to ease. The transparent policy mantra will have everyone priced in and hedged up. A 50bp move collapses the time frame of expectations, not the final outcome.

Of course the market will be 100% wrong because the shock won't end up adversely impacting the economy at all and expectations will soon begin pricing in a string of 50bps tightenings, although not for a long enough amount of time in my opinion. If we have learned anything these past 25 years, though the street seems to have forgotten, it is that the U.S. economy is more interest rate insensitive. The level of real rates required to slow the economy has moved higher. Why? The old regulatory circuit breakers have long been deregulated and financial innovation has allowed everyone to float assets and liabilities.

So there are two issues with a "shock 50". First, market expectations adjust the whole curve rather quickly to fit the new policy and everyone borrowing against the curve adjusts accordingly. Given that the economy floats on both sides of the ledger, the net impact will be small. Second, levels are still way too low to curtail credit expansion. Other things might put a halt to borrowing and lending, but it won't be the cost of money.

Getting back to the adjustment issue, herein lies a fundamental problem with a transparent Fed at this juncture of the business cycle. Gingerly raising interest rates from a near deflationary environment required alot of hand holding, etc. in order to get rates where they needed to be without people losing confidence. The problem now is that If everyone knows whats coming, the markets price it in and businesses hedge it up. At some point, later rather than sooner, Poole will be making a transparent attempt at convincing the world that an opaque policy is the best alternative. How do you do that? Take a page from Volcker -- target reserve growth and let the market price Fed funds.

If you can no longer count on a rational and known path for funds, what then? The impact on the real economy could be negative -- if rates are high enough.

We are far from the need for any of this, which is why 50bp is far from reality. The economy is not in the midst of runaway growth. But I do know this, if you think the well-telegraphed slow but steady policy that has created the trajectory of 25bp moves followed by plateau and then ease, and all within the next 12 months or so, is going to slow growth -- think again.

Bernanke leads the way again....with an interesting add

2006-06-19T16:09:00.000-04:00

Bill Poole's most recent talk at a Bank Korea Conference on June 16 makes for fascinating reading. He often says what Bernanke can't, or at least shouldn't say directly. The main thrust of the speech is that the FOMC can and often should rely on anecdotal information well before the official stats in determining the course of policy. The following paragraph from the speech is a good summation:

"In the absence of precise statistical forecasting models, another potentially useful source of information to assess the stability of inflation expectations and the likely course of the real economy is real-time anecdotal information. The drawback of anecdotal information is that there is no scientific basis for the sample. Yet the accumulation of forward-looking anecdotal information at critical times can be informative. An example can be drawn from the recently released transcripts of the FOMC meetings of October, November and December, 2000. At that time, the best inference from statistical forecasting models was that economic growth in the U.S. would gradually slow from the very high rate of the first half of the year to rates that were regarded as more sustainable. Yet, also at that time, more and more FOMC participants were reporting stories indicating sharply slowing conditions from an ever increasing number of respondents. We now measure real growth in the second half of 2000 as less than 1 percent (annual rate), with negative growth in the third quarter. In this instance the anecdotes gave a better early warning signal of the turn in activity than did the forecasting models."

In other words, also from the speech:

"A similar situation may prevail today. Statistical studies to detect pass-through from recent energy price increases have failed to show significant effects in U.S. price data but stories about widespread pass-through are becoming increasingly common. We may—and I emphasize “may” because my purpose is to make a general point and not to conduct a full analysis of the current situation—face more inflation pressure than currently shows up in formal data."

Meaning -- Fed in August is pretty clear unless there is a collapse in final demand. Possible but today's Beckner article puts the Fed's perspective on going too far in a clear light:

"Despite 400 basis points of tightening, the Fed does not regard overall
credit conditions as being restrictive. There is ample liquidity to fuel
continued expansion in a resilient economy that has often outperformed
forecasts.

Even if it believes the tinder for an inflation flare-up is lacking and
that the recent bulge in inflation is fundamentally transitory, officials
stress that they must guard against letting inflation expectations take on a
life of their own and fuel an acceleration of actual inflation.

So the prevailing Fed view is that this is not a time when the Fed
should take chances with inflation.

If need be, rate hikes can be reversed. The Fed can and will undo rate
hikes that later prove to be unnecessary, and it is hoped that the markets'
knowledge of that possibility would tend to cushion the impact of further
rate hikes."

As I have been writing, only the "Street" thinks money is tight. A piece written by Stephen Cecchetti of Brandeis University, breaks down the recent CPI numbers and stated that the Fed is now going to 6%. He is right in assuming that 6% is the beginning of tight money. The world is at least beginning to migrate to my view that there is much more to come before credit is constrained and an immediate collapse in growth, at least from the credit side, is not forthcoming.

In sum, the Fed has officially let us know that if the anecdotal evidence points to inflation, they aren't waiting for the data. They have more to lose by waiting and allowing inflation expectations to become unglued than by going too far and then reversing and, as Beckner notes, hoping the market recognizes this flexibility in Fed policy. Does the Fed really want to go so far as to constrain credit and risk recession? At what point does nominal GDP growth drop down to the funds rate and at what point do they stop and wait? Based on this new information, they won't. They are intent on moving forward regardless. We will see. Tough talk oftens hides an easier policy and the Fed, since 03, has been very easy.

But the real news with the Poole speech, at least to me, is that he has brought money supply growth back into the picture.

"The observation that correlations are changing or disappearing does not mean that the economy has fundamentally changed. In particular, it is likely that the correlation between the growth of monetary aggregates and the inflation rate (or even nominal income growth) will be small in low inflation environments. Yet central bankers who fail to monitor the growth rates of monetary aggregates do so at their own peril. History illustrates that rapid and accelerating monetary growth, positive or negative, is a recipe for the demise of the low inflation regime into inflation or deflation. Just because a low inflation environment has been established, central bankers cannot print money without restraint. Large correlations, then, provide evidence that the central bank has failed to exploit relevant information; as policy becomes more effective, correlations tend toward zero."

Why news? First time in a long time that the Fed has mentioned money supply. Also interesting is juxtaposiing his comments with the recent behavior of money as we can easily see in the St. Louis Fed Publication on U.S. Financial Data. Isn't that the place Poole runs? Anyway, the data show that monetary growth is not accelerating and seems to be plateauing, same for credit demands. This may be a bit seasonal but the inclusion of money into the speech at this moment suggests, perhaps only to me, that the Fed is going to listen to gossip and rumor in determining whether to tighten further while ignoring money supply -- if it is slowing down while inflationary evidence is on the rise.

So, if Keynes once changed his mind when he got new information, who am I not to take this new and take a step back from "August And Done". Holding at 5.5% now seems less likely. Moving to 6% is becoming more likely. I have written that 6% was the beginning of truly tight money, questioned the politics of really going after a slowdown in growth. Is there a value in shocking the market with a suprise 50 if things don't ratchet down by the early fall? Perhaps they recognize what Greenspan left them and realize they have no choice.

CPI Up, Markets Down, What Next?

2006-06-14T12:02:00.000-04:00

David Altig brought out the current thinking of the Fed on inflation as written by John Berry. Basics: No inflation spiral, current level is too high but economy is moderating. Result: Another 25 in June as insurance, we will see about August. My thought: To accept this line of logic one has to be convinced that the economy is heading south and that we are witnessing the usual lead/lag relationship between growth and inflation.

Lets take another look at this inflation news for a moment and ask the question everyone assumes is not relevant: How much of our good inflation of the past decade is owed to disinflationary policies and how much to the pricing of goods and services determined outside the U.S. Counting angels on the head of a pin? Not really, because we are in an inflation targeting monetary policy and, if foreign influences dominate, which inflation are we curbing and how is it working? I understand the feedback effects, but lets just talk first order influences and leave the rest to graduate students searching for a thesis topic. Also, reading what most people write, there is alot of partial equilibrium analysis going on anyway.

So, in the 90s disinflationary monetary and fiscal policy. Budget discipline and a narrowing deficit with revenues fed, for the most part, by capital gains taxes. Monetary discipline, the spread between nominal GDP growth and Fed funds was exceptionally narrow throughout the period. Overseas? Weak oil, weak commodity prices, no real China influence (whatever happened to those Tigers?), all indicators of soft global growth.

Today, easy monetary and fiscal policies. Rest of world is growing, oil and commodity prices indicate that, as does the growth of China. Easy money? Ask any corporation or venture capitalist looking to raise funds and ask them. Are we sitting on a growing inflationary bubble that is being fed because the gdp/gdp potential gap is shrinking around the world?

Putting a disinflationary policy mix back in place in a "guns and butter" political climate is tough, so the Fed talks tougher than they are. Fed stops soon, because no one wants recession.

If there is a risk to current expectations (as evidenced in the market by people who place their bets rather than talk them) it is that the Fed keeps going because the economy keeps going. As I noted yesterday, if the CPI came in worse than expected, front end of the curve would steepen. The jun06/jun07 euro$ spread has steepend 7 basis points. That leads to what next? Of course there will be lots of talk about August and Sep in the coming weeks as new data arrive. To me, the real opportunities lie in the 07 contracts -- that is where the coming ease is priced in. Markets still want to believe the economy is grinding to halt due to tight money. In my humble opinion, the grind will occur but not yet.

Waiting on Inflation, Looking At the Numbers.....

2006-06-13T11:04:00.000-04:00

Markets sitting this morning waiting for the CPI numbers. Not quite sure what it is anyone is expecting. I am not going to guess what the number will be, I will leave that to others, but I will venture to say that regardless of the number, the Fed is going in June -- that is stating the obvious. What matters most now is what string of data, over how many months, stays the Fed in August and, of increasing importance, September. The present run shows a cumulative probability of 117% tightening by August and less than 9% through the rest of the year.

So, the key really is August. If the market starts moving it to 50/50, it will pull up the probabilities of others and steepen the front end of the curve. The red Euros (not communists, or Bush voters, the next series of euro futures after the first four) will move to higher rates as well but more than likely keep their shape -- negative slope. Why? Everyone, or at least most everyones in the market, are betting that the economy will slow and the Fed will be easing.

Want to bet against the curve? Rather than playing the 2/10 curve trade, look for something interesting to do in the red Euros.

Getting back to CPI, a good number is one month, Fed needs more evidence than that, so changes nothing much. A bad number, probability of August ratchets higher.

What do I think? Economy is fine, 5.25% money is still cheap, Fed will stop soon but the economy won't.

The 5.25% Solution -- Fed done in June?

2006-06-06T17:32:00.000-04:00

Ever since the Volcker era took hold, the Street sees the Fed driving the funds rate too high and about to crater the economy -- well before the Fed. They have been right a few times. This isn't one of them.

Current worries have been in vogue since at least last year, when Fed funds passed 3%. The market's predisposition has been to price in one or two more tightenings and then done and then -- when's the first ease? This pattern is like a loadstone -- no matter what happens or what the Fed says. Why? The market was convinced that the economy would slow as consumers were hurt as housing collapsed under the weight of higher mortgage rates and $40 oil. The Fed's forecast was better than the street's. Looking forward, it still is.

The market and its gurus got really worried the other week on the heels of weaker-than-expected employment data. Enough so, that the Fed had to set every one straight, again. They let us know that 100,000 new hires a month is probably right for an economy growing at 3%, and that while the economy might be moderating to where they want, the magic low 3s, there isn't much slack and inflation continues to edge up and, lo and behold, inflation expectations are moving up as well. They even trotted Greenspan out to let every one know that high oil prices haven't dampened growth. The Street seems convinced that 5.25% funds plus $70 oil means an ease beginning next week (check out the euro$ strip, its all there in black and white, black and amber(?) if you are looking at a Bloomberg).

What does it mean? Fed goes in June (every one knows that), but the opportunity is that the market believes they won't go in August. Price of Augy funds suggests no way for it to go up unless Fed eases and for it to drop almost 20 ticks if the Fed tightens -- all assuming Fed tightens 25 on June 29.

From my perspective, the Fed reaction to the employment data means it is more likely to go in August than not. Economy is fine, money is cheap, credit is plentiful, and the weaker dollar is helping capex. Stock market is probably more worried about inflation, adjusting p/e accordingly, than it is worrying about weaker profits. On the other hand, hey I am an economist and this is why no bet is certain, Fed needs growth and asset inflation. There is no rational reason for them to put the brakes on the economy.

Inflation, over time, will increasingly become a problem. All these past years of all the central banks pumping liquidity into the system! At some point, financial assets are swapped into physical goods and with a vengance. Its begun, and its only the beginning. Quite a spot Mr. Greenspan left for Mr. Bernanke. In the meantime, 50/50 for August and lets stop looking for the big slow down -- it is a long way off.

MADness in Bonds. . . . . . .What's Next?

2006-05-26T19:45:00.000-04:00

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.