4 Year Presidential Cycle: Bond edition
"With so many investors concerned over interest rates, we wondered if they follow cyclical tendencies as well. The chart to the lower right plots the YTD percent change in the ten-year bond yield vs the average YTD change in ten-year yields during the second year of a presidential term. Like the chart for the S&P 500, this year is following a similar pattern to the average, although the magnitude of the move this year is considerably greater than the average move. This would imply that bond yields are near their peak for the year."
If the cycle holds true this year, bond yields should be heading lower in the second half, with allthat implies . . .
10 year bond change, 4 year cycle
Source: Birinyi Associates, Inc.
Ignore Inverted/Flat Yield Curve at Your Own Risk
We have discussed the impact of an inverted yield curve repeatedly in the past. Much of the mainstream has denigrated the historical record of using this relative unusual relationship between yields as an indicator. They have strained credulity to somehow reach the conclusion that it really is different this time.
From Birinyi Associates, here is the recent track record of what they call "Intentional curve inversions:"
Source: Ticker Sense
This seems pretty conclusive that there is a correlationn between the shape of the curve and subsequent recessions.
And these tidbits from Jim Stack of Investech Research agrees. He points out:
• The flat yield curve shows an 88% probability of a recession beginning sometime between now and the end of next year.
• The yield on the 10-year Treasury Bond hit new 4-year highs this week.
• Even excluding energy, the CRB Spot Raw Materials Price Index is showing the highest 4-year inflation
rate in 25 years.
• Of the past 10 tightening cycles by the Fed, only 2 resulted in a soft landing (without recession).
June 30, 2006
Technical and Monetary Investment Analysis
Investech Research, June 30, 2006
A Deceptively Simple Timing System
Interesting column by Mark Hulbert in the Sunday NYT about an econometric model I have observed over the years and have been impressed with.
What makes it so interesting is the deceptively simple system for assessing risk versus reward in the market place. It does so by tracking just three items: Stock market Dividend Yield, interest on the 90-day T bill, and the median 3 Year Value Line analyst earnings projection.
Taken together, they forecast trouble for the next 6 quarters:
"The model arose from research conducted some 15 years ago by William Reichenstein, a professor of investments at Baylor University, and Steven P. Rich, a finance professor there. They reported their results in an article in the summer 1993 issue of The Journal of Portfolio Management.
The model is quite simple, especially when compared with many econometric models. It has just three ingredients: the stock market's dividend yield, the interest rate on 90-day Treasury bills and the median of projections from analysts at Value Line, the investment research firm, of how much the 1,700 stocks they monitor will appreciate over the next three to five years. The first two numbers are readily available at many financial Web sites, and the third is published weekly in the Value Line Investment Survey. The formula for combining the three pieces of data can be easily figured with a spreadsheet program or a calculator.
Despite the model's simplicity, the professors found in back testing over the period from 1968 through 1989 that its periodic readings had done an impressive job of forecasting the stock market's gains and losses over the subsequent six calendar quarters."
What makes this so fascinating is that the three elements are unbiased and uncorrupted: the market's dividend yield is real money paid by companies to shareholders, so it cannot be phonied up (even the dividend tax cut only had a minor impact on it); the 90 day T bill interest is also a market determined element. While it is impacted short term by the Fed, it is ultimately set by the bond market; Lastly, the median of projections from analysts at Value Line are free from Investment Banking and/.or Marketing pressures (and other stupidity). Value line has an outstanding track record, and they are completely unbiased and objective, untainted by sellside conflicts.
Here's a chart of the timing model's forecasting history:
graphic courtesy of NYT
The model forecasts that "the market is likely to underperform garden-variety money market funds through the end of next year." That gloomy forecast is quite consistent with out expectations.
Hulbert notes that the market-timing model "while not perfect, has had an impressive track record over the long run." He writes:
"To be sure, the model has had a mixed record in the 13 years since their study appeared. Though the model has performed well in the current decade, its record in the 1990's was poor. Through much of that decade, it projected below-average performance for the stock market, thereby greatly underestimating equities' actual returns.
The model's failure in the 1990's, however, may be the exception that proves the rule. In an interview, Professor Reichenstein contended that the stock market's outsized returns in that decade were in large part attributable to investor "irrationality," and that the model should therefore not be faulted for failing to forecast them. The model aims to forecast what the market's level would be if investors were rational, and "no model built on rational pricing is able to explain irrational behavior," he said.
A study by The Hulbert Financial Digest provides further support for the notion that the model's failure during the 1990's was an anomaly. The study focused on its performance from 1968 through 2006 — a period that includes the 22 years covered in the professors' original study and the 17 years since. Even after the incorrect forecasts in the 1990's are taken into account, the model's overall record is good enough to be statistically meaningful and not likely to be mere luck."
My only issue is that the time period involved is kinda short and limited -- it covers most of one bear market (1970-82) and all of the next bull market (1982-2000). Valueline started in 1931, so it would be interesting to see how this system did during the prior post WWII Bull market -- especially given the model's miss during the late 1990s moonshot.
That might provide some insight into whether the system misses these types of strong markets. Or, it might just suggest that the 1995-2000 period was extremely aberational. Either way, it could provide insight into that one predictive failure.
An Old Formula That Points to New Worry
MARK HULBERT, Strategies
NYTimes, June 18, 2006
A Consensus is Developing: Blame Greenspan
I love when an idea simultaneously blooms all over at once.
If we saw the same meme suddenly pop up all over the mainstream, that would be one thing. My assumption would be that it was today's takling points, and I would be a lot more sleptical.
But when 4 pretty independent thinkers all reach similar conclusion, I pay close attention.
First up, Jeff Matthews wrote this on Tuesday:
“Every time he opens his mouth, the market tanks.”
That’s what I kept hearing during yesterday’s market sell-off.
“He” is, of course, Ben Bernanke, the poor guy who had to follow in Alan Greenspan’s hallowed footsteps as Chairman of the Federal Reserve.
Under Bernanke, the Fed has raised interest rates precisely twice. Under Greenspan, the Fed raised rates fourteen times. But, under the twisted laws of Human Nature, Bernanke is Guilty as Charged. His crime: spoiling the party.
Now, Greenspan raised rates fourteen times because he had previously dropped them to virtually zero, triggering the greatest home-building speculation boom in the history of the country. Al figured—and with his reputation in Washington, who was going to argue?—the Fed could gently deflate the Greenspan Housing Bubble in a way that everybody would win.
But Bubble aftermaths are never pretty.
Just look at the last one. It occurred only five years ago, when Greenspan himself tried likewise to gently deflate the greatest new-era business speculation boom in the history of the country—the Greenspan Internet Bubble—and triggered a recession.
So, who’s the villain here? A guy who tells the world inflation is running a little high and maybe rates aren’t necessarily going down any time soon?
Or his predecessor, whose twenty years in control led directly to $70+ oil, $300+ copper and $600+ gold?
Next up is Doug Kass' musings (Wednesday)
Don't Blame Bernanke: Investors' inertia (and highly leveraged invested positions in overvalued market, which served to reduce risk premiums to preposterously low levels) is one of the situations that should be blamed for the recent market slide and increased volatility. At the slightest hint that the Fed might have to go further, their portfolios were decimated in short order. Stated simply, they got greedy and lacked foresight. Don't blame Bernanke.
Greenspan Is the Real Culprit But the real culprit -- never discussed on CNBC, Bloomberg or elsewhere -- is former Fed Chairman Alan Greenspan who not only raised interest rates on 14 separate occasions (before Bernanke's paltry two increases) but who previously took interest rates to artificial and generational lows (the fed funds rate bottomed at 1%). That strategy's economic impact was to usher in another bubble (in real estate), which served to stoke consumer spending through the extraction of capital out of the housing stock. In turn, commodities followed housing ever higher. By the time the new Chairman took over in early 2006, today's problems were already percolating. Blaming Bernanke for Greenspan's mess would be like blaming Ed Breen, who followed convicted crook Dennis "Denny the K" Kozlowski as CEO of Tyco (TYC). Don't blame Bernanke.
Post Late 90s Policy Decisions Created Today's Market Position The unusual nature of policy decisions post the late 1990s bubble served to put the markets in the position they are today -- a position inherited by policy makers. As a result of the aforementioned monetary loosening, for the first time in modern economic history, consumer debt (installment and mortgage) increased in the recession of 2001-02. A series of 14 incremental and gradual tightenings, intended to wean our economy off of easy money, sowed the seeds of the inflation we see today. Don't blame Bernanke.
Acknowledge Other Causes for Market's Decline So, blame the market's decline on avaricious and poorly positioned hedge funds, on former Chairman Alan Greenspan bubble-inducing monetary policy, or on the natural cyclical nature of markets, or "Blame it on the Bossa Nova." But don't fixate and blame Ben Bernanke.
Then last night, Slate's Dan Gross was even more specific, saying, The Ghost of Greenspan is haunting the Fed:
But Bernanke's rhetorical vacillation isn't the Fed's sole contribution to the recent volatility. It's his new methods. Last week, Bernanke told a Senate committee that economic data released in the coming weeks would help determine whether the Fed would raise rates at its next meeting at the end of June. "Our thinking on this will be very data-dependent." Now, the Fed has always been "data dependent." But the implication of Bernanke's comments was that the Fed would essentially make decisions on the fly, based on the latest headlines. So, every time a new piece of information comes in, like last week's lame jobs figure, investors have to guess at how that might impact the Fed's decision. The fact that economic data are frequently contradictory contributes to investors' confusion.
In theory, this type of transparency and disclosure was precisely what the market wanted from the new Federal Reserve chairman. For years, investors have complained that Greenspan's Fed was too opaque, too hard to read. But now it turns out that trying to interpret public data is even trickier than interpreting the oracular Greenspan.
The Bernanke-era volatility can also be blamed on the stature gap. Under Greenspan, the Fed generally spoke with a single voice, Greenspan's, and didn't engage in any public debate. Sure, the other Fed governors and heads of the Fed's regional banks were well-respected economists. And, yes, their testimony and comments were dutifully reported by the financial wire services and picked over for clues as to what the Fed might do next. But they were like so many planets to Greenspan's sun. Today, as would have been the case regardless of Greenspan's replacement, Bernanke lacks Greenspan's weight. And as a result, the comments of people who were perceived as peripheral players in the past now have a greater capacity to move the markets.
Lastly, Marketwatch's David Callaway puts this all into context:
"But what the market is missing among all this tough talk is that transparency from our financial leaders is a good thing. Sure he spooked the markets about inflation. But should they really have been that spooked?
In its traditionally coded way, the Fed has been banging the drum for more than a year about inflation. But with no visible signs of it -- other than soaring energy prices -- investors didn't believe the central bank. Now they do. It took plain talk to accomplish that.
What the market is also missing is that just as plain talk can scare investors, it can also excite them. The day will come when Bernanke will blurt out something positive for investors, like "I think that should do it." Then it's off to the races.The problem with the financial markets is a lack of transparency. That's why an entire industry has grown around central bank watching. Trying to decipher what these bankers are saying is a global financial pastime. Economists and financial journalists spend their lives studying snippets of sentences for underlying intent. Now we have Bernanke to spell it out for us and we're upset?
For the markets, this is tough medicine. But they had a great run in the first quarter and in April, and we're overdue for some sort of setback.
UPDATE: JUNE 12, 2006 6:57AM
Bloomberg joins in: Bernanke Can Thank Greenspan for His Troubles
"If you consider that a "neutral'' federal funds rate is probably around 4.5 percent, and that the rate was below that all of last year, one must conclude that the Fed had its foot on the gas right up to Greenspan's departure. We are in this difficult spot because the Fed was far too easy when growth was hot last year, leaving all of the tough work for Bernanke.
Whenever there is a tightening cycle, markets are always puzzled and dismayed by the question, "When will the tightening end?'' If Greenspan were at the Fed right now, market volatility would be the same, because the Fed's uncertainty about when to stop would be the same.
He isn't at the Fed now, and somebody else is, a person who is supremely able to deal with the difficult task of managing monetary policy. But Bernanke's job would be a lot easier now if the Fed had simply increased the federal funds rate enough last year so they could have halted the increases in Greenspan's last meeting in January"
Shooting the Messenger
Jeff Matthews is Not Making This Up,
Tuesday, June 06, 2006
The Blame Game
The Edge, Street Insight 6/7/2006 7:31 AM EDT
The Ghost of Greenspan
It's haunting the Fed.
Slate, Wednesday, June 7, 2006, at 6:39 PM ET
Loose lips Bernanke just what market needs
Commentary: Tough talk brings transparency
MarketWatch, 12:01 AM ET Jun 8, 2006
Worst Case Scenarios: Why the Fed Tends to Overtighten
Forget, for the moment, the specifics of the May 10 Fed Minutes. Instead, consider the decision making process the FOMC goes through.
When making complex decisions with serious ramifications, it is useful to understand what is at risk if you are wrong. That one factor impacts various outcomes dramatically.
Its a given that the future is unknowable. The complexity of the economy, random events, unexpected interactions, dumb luck -- force all forecasters to recognize the inherent possibility, and indeed, high likelihood of error. Typically, that recognition colors policy making. (Consider recent examples where expectancy analysis was ignored in the policy making process -- with dire results).
Once you get through that process of error expectancy, then play out the various decision tree possibilities: The results are why the Fed tendency to overtighten is all but a fait accompli.
And, we like it that way.
Why? What is the worst case scenario if the Fed Overtightens? The economy slows, maybe we even have a recession. Not to make light of what is always a painful situation, but -- so what? Recessions are a normal part of the business cycle. The U.S. economy is flexible, multi-faceted and resilient enough that a mild recession -- or even a strong one -- is a minor inconvenience in the grand economic scheme of things.
Consider: A recession reprices overvalued assets; It creates a cathartic cleansing that forces efficiencies where there were none before. It removes excesses that have developed.
Has the U.S. ever not bounced back from a recession? Of course not. Over the next century, we will have a dozen or more recessions, and an equal number of recoveries.
But consider the alternative error: What happens if Inflation is no longer contained -- if it gets away from them?
That is a far, far worse outcome than a recession. I am old enough to remember the nightmare of the 1970s. I have no desire to live through THAT again (and I'm not referring to Disco, Bell bottoms or Nixon). It was FUGLY:
1970s Inflation: Worse than Disco
Once inflation is no longer contained, it becomes a runaway wildfire. The Fed -- indeed, central bankers everywhere -- find it difficult to play catch-up. Inflation is self-reinforcing -- it forces everyone in the system to raise prices, pass along increases, demand higher wages. It feeds upon itself.
The response? The Fed goes Volcker (now, a verb) on the economy: They force an even more severe recession. The medicine to recover from this is a brutal, economic chemotherapy. It can take a decade to recover from uncontained inflation -- or the cure.
That's the dilemma confronting the Fed. What is the worst case scenario if they are wrong and overtighten? We get some unpleasantness -- but nothing fatal. No one likes recessions, but they are a natural part of the business cycle. (We don't care for death either, but its a part of life). After the Recession, comes the Recovery.
This is why the Fed tends to overtighten. We always -- ALWAYS -- rebound from a recession. Relatively quickly, also. But 1970s-style inflation is a spectre that haunts the dreams of all economists -- especially those who sit on the Fed.
Given this choice of potential negative outcomes, what would you do?
Yield Curve Inversion
Anyone else notice the brief Yield Curve Inversion this week? The 10-year yield slipped below Fed Funds rate for first time since the last recession.
Chris Isidore of CNN Money has the details:
"The inversion early Wednesday was different than the inversion that occurred late last year and early this year, when the 10-year Treasury yield fell below the yield on shorter-term Treasury securities.
Wednesday's inversion came as the 10-year yield fell briefly below the fed funds rate, the Fed's short-term rate target, currently 5 percent. It was the first time that's happened since April 2001, the last time the country was in a recession.
The 10-year yield dipped briefly below the fed funds rate Wednesday morning after a report showed a big drop in demand in April for cars, refrigerators and other big-ticket items known as durable goods.
But when a report on new home sales came in above forecasts 90 minutes later, the 10-year Treasury yield edged back above the 5 percent level."
I continue to believe an economic slowdown is in the offing as stimulus fades, and the pig moves through the python. Recession odds for 2007 keep increasing. This despite what Ben "CPI overstates Inflation" Bernanke has said:
"But in recent comments, Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead.
"In previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint," Bernanke said in a speech in March. "This time, both short- and long-term interest rates -- in nominal and real terms -- are relatively low by historical standards."
Keep in mind that inversions are not binary -- i.e., inversion or not. The depth and duration of an inversion are significant and contain information. The inversion this past Wednesday was "short-lived and relatively narrow. Some of the pre-recession inversions in the past were far more pronounced." Compare this with prior inversions:
"For example the gap between the 10-year yield and the fed funds rate were inverted for nearly 11 months and the gap reached 1.5 percentage points in January 2001, just before the Fed started cutting rates.
The recession that started in late 2000 lasted until the fall of 2001.
Still, an inverted yield curve is not something that can be ignored, the experts said.
"I think it would be healthy to be concerned, given the track record of the curve being a warning sign," said Schlesinger. "It's important not to be trapped by past patterns. But it (the inverted yield curve) does raise a question about how far the Fed has to tighten."
Yields throw the Fed a curve
CNNMoney.com, May 24, 2006: 3:35 PM EDT
Dear God, Please stop talking about 1994-95
Last night, the comparison came up with recent selloff action and 1987. But the more frequent relative comparison from the perma-Bullish camp is 1994. That's the year that gives some folk -- most notably, Don Hayes and James Cramer -- comfort in the belief that the market is safe from a major correction at this time.
Ryan Fischer destroys that argument. I thought his observations on this frequent Bullish comparo between 1994 and today were very astute. Since he does not publish anywhere else -- and I liked his piece a great deal -- I offered Ryan the Big Picture as a platform to publish this.
As always, feel free to comment . . .
Dear God, Please stop talking about 1994-95
The Winds of Cost of Capital
By Ryan Fischer, 5-20-06
Please, please, I beg of you: quit talking about 1994-995. 2006-07 has no similarities whatsoever -- except in your hope.
Does anyone remember what the bond market did in 94-95? Anyone? The yield on 10 yr treasuries went from basically 5.5% at the beginning of 94 to 8% by year end. That being the number the bond market erroneously thought the FED would go to. By the end of 1995 the yield on the 10 yr was back at 5.5% a dramatic easing of financial conditions. And, on cue, assets went wild, housing and consumption caught the wind in their sails coming off the bond market and off Risk ran.
Consider: For us to experience the same winds of easing of financial costs today yields on 10 year Treasuries (currently 5-5.2%) would have to decline to 3.5-3.7%. What kind of macro environment would we be in if 10 year Treasuries were yielding 3.5-3.7% six to twelve months from now? Hello deflationary soup!! That or some crisis that has convinced Helicopter Ben to deploy the "Unconventional Measures" he talked and wrote about during his emergence. Friends, if the Fed is buying 10 year Treasuries and causing a 3.5-3.7% yield we might as well take the stars off our flag and replace them with a hammer and sickle.
A forewarning: Whenever you hear or read about Unconventional Measures from the Fed or the Treasury think State Interference in Free Markets. And we all know where that leads and ends.
But, I digress, as this missive is primarily about the cost of capital, its percentage change and the effect that has on risk assets.
Whenever you hear someone mention historically low interest rates while supporting their bullish argument for whatever risk asset they are buying, holding or selling, immediately mark them down in your book as financially illiterate. (Note, this argument is often heard from the CEOs of public builders, their real estate brethren and the sheep who follow, plus equity pushers.)
Let me say this: It is not the absolute level of the rate of interest that matters to those who allocate capital, it is the relative rate of change.
Let me elaborate: Everyone likes to pull the grandpa "I remember 15% interest rates in 1982, so 5% today is really historically nothing to be afraid of" (Again note; This is another favorite of anyone selling, holding or pushing real estate). Lets think about that intellectual construct for a second and see if, as a person who allocates capital, if it would sway where I push my dollars.
Because interest rates were around 12-15% in 82-84 and today they float around 5-5.2% (ten year Treasury yields on both) I therefore should be more willing to employ my capital in risky assets because money is so much cheaper today than some 22-24 years ago.
First, let me say I will not even touch on the subject of valuation, though the argument about then vs. now should be clear to any open seeing eyes.
Rather, let us focus on the cost of capital. As a speculator, entrepreneur, investor, etc..etc..those absolute levels mean nothing to me. For all I care, interest rates could have been 80% in 82 and the argument about historically low interest rates today still will not sway me. In fact, I'll tell you I'm more excited about a 10%, 9%, or a 8% rate of interest in 85, 86 and 87 than I am about a 5% rate of interest in 2006.
Its obvious, isnt it? 16% in 82 to 9% in 85 is a huge, huge tailwind at the sails of risk assets. This is a dramatic easing of financial conditions. Also, trust that asset prices failed miserably for many, many years to reflect this change. Such are the effects of psychology and the enhancing fruits of under-valuation. The world is nearly without clouds when interest rates fall so dramatically (kind of like 2000-2003). Is the world equally not dark vs. 85(15% in 82 to 9% in 85) or as sunny as 94/95 (again, 8% to 5.5%) now that rates have gone form 1% to 5% on the short end and 3.5% to 5-5.2% on the long end.
Based on the cost of capital, when are you a buyer? When interest rates decline by 40% (15% to 9%) or increase by 45% (3.5% to 5.07%)?
To risk assets, the cost of capital is like the wind. It is the change from the start of the race that matters, the more headwind the more trouble, and the more wind one can summon to their back, the faster the ship sails.
God what I would give if this was the mind frame today. Imagine if after an ever bullish provocateur sighted historically low interest rates as part of their argument if the financial journalist queried them with Sir/Madam, are you saying you are more of a buyer when the cost of capital has gone from 3.5% to 5% than you are when the cost of capital has gone from 15% to 9%? Imagine.
But always know which way the winds of the cost of capital blow.
Red Fisch, LLC
Ryan Fischer manages assets and capital for his family and a
few private clients out of
What Would Greenspan Do?
That's the question the WSJ's Greg Ip asks:
"Should the Fed worry more about rising inflation and raise rates further, risking a recession? Or should it worry more about growth and hold rates steady, risking higher inflation and a loss of credibility? The outlook for global stock and bond markets will hinge on the outcome of that decision."
As if we don't know WWGD: The short answer is, he would flood the system with liquidity. The longer answer involves opaque speechifying about systemic risks and global resilience and blah blah blah, as he released the hounds of M3 into the ether. (more money supply! Faster! Faster!)
The column references an academic study co-authored by Bernanke that concluded "economic growth begins to slow roughly six months after the Fed tightens monetary policy. But inflation doesn't begin to ease until about year has passed."
The net result of this is the conundrum we referred to last week, with the Fed painted into a corner.
Here's an excerpt from Ip's column:
"The result often is an uncomfortable period when growth is slowing, inflation rising and the central bank facing a tough choice between higher rates and watchful waiting.
That may be where the U.S. economy is now. After a first-quarter surge, growth is slowing, as higher interest rates and energy prices take their toll on housing and consumer spending. It "seems pretty clear that the housing market is cooling," Mr. Bernanke said Thursday, though the slowdown is quite "orderly and moderate." But core inflation, which excludes food and energy, reached a one-year high of 2.3% in April.
Markets have gyrated on the economic crosscurrents and bond yields reflect a rising concern about whether Mr. Bernanke will hold inflation low over the long term. "With core inflation crawling up, a new central-bank chairman is clearly not going to want to let inflation expectations go up," Mr. Gertler said.
With the Fed having raised its short-term interest-rate target in 16 quarter-percentage-point steps to 5% since June 2004, some at the central bank appear to favor pausing soon to assess the impact of those moves on the economy."
Today's futures look like hell (glad I got stopped out of longs last week). If we see a serious whackage today -- and it sure looks like we might -- that will resurrect the possibility of a pause in June.
Here is everyone's favorite faulty comparison: 1994 vs 2000 vs 2005
click for larger graphic
As previously noted, the better comparo is 1973.
Trade safe today -- it looks like it could get ugly out there.
What Would Greenspan Do? Bernanke Weighs
Risks of Rate Increases and Rising Inflation
WSJ, May 22, 2006; Page A2
SPX to the 10-year Yield Ratio
The breach of a key uptrend in the ratio of the S&P 500 to the 10-year U.S. government bond yield suggests either stock prices are headed much lower or bond yields are headed much higher -- or both -- in the longer term.
Source: Mike Panzner
To Pause or not to Pause
How bored am I waiting for the next Fed Statement?
To Pause or not to Pause, that is the question:
Whether 'tis nobler in the mind to suffer
The slings and arrows of outrageous commodity prices,
Or to take arms against a sea of rising yield troubles,
And by opposing inflationary trends, end them?
To halt: to stop tightening; No more; and by a tightening to say we end
The heart-ache and the thousand natural shocks of incremental rate increases
That Treasuries are heir to, 'tis a consummation
Devoutly to be wish'd by equity traders. To halt, to cease;
perchance to dream of the end of the rate cycle: ay, there's the rub;
For in that sleep of death what dreams may come of runaway inflation
and gold priced over $700 an ounce.
When we have shuffled off this mortal coil *(and into the private sector),
This must give us pause: there's the respect of bond ghouls,
That makes calamity of markets domestic and foreign;
For who would bear the whips and scorns of said ghouls verging on madness
The oppressor's short selling, the proud man's margin calls,
The pangs of despised Sarbox, the law's delay,
The insolence of regulators and the spurn of taxes
That patient value investors merit of the unworthy day trader takes,
When he himself might his quietus FOMC make
With a bare bodkin? Who would fade the bull and buy the bear?
To grunt and sweat under a trader’s life,
But that the dread of something after Spitzer,
The undiscover'd buy side from whose bourn
No broker returns, puzzles the will
And makes us rather bear those deficit ills we have
Than fly to slowing economic growth that we know not of?
Thus conscience does make cowards of us all in the wake of worsening inflation expectations;
And thus the native hue of resolution at FOMC meeting
Is sicklied o'er with the pale cast of the steeper yield curve and greater TIPS spread,,
And enterprises of great pith and Crude Oil
With this regard their currents turn awry from the weaker dollar,
And lose the name of action. – Softer rates you now say!
The fair Ophelia! Nymph, in thy orisons and increased demand for inflation-protected securities,
Be all my sins remember'd.
To be, or not to be (from Hamlet 3/1)
With my deepest apologies to William Shakespeare
Chart of the Week: 10 Year Yield, 30 year chart
John Roque notes most investors he’s spoken with “continue to have difficulty considering the major transition that’s occurred for the 10 year Treasury yield – it was going down and is now, incontrovertibly, going up.”
10 Year Yield, 30 year chart
Source: Natexis Bleichroeder
Even the more modest downtrend (the lighter less severe line) has been penetrated to the upside with the 10 Year hitting 5.143% on Monday.
Quote of the Day
“Great spirits have always encountered violent opposition from mediocre minds.”
–Albert Einstein (1879-1955)
One Two Three & Done (The Sucker Play)
Once again, the One & Done crowd has managed to pull the PermaBull traders into a long side bet, following the spin 2 weeks ago after the March FOMC minutes were released, and last week's JEC testimony by Fed Chair Bernanke.
Over the weekend, Fed Chair Ben Bernanke told CNBC's Maria Bartiroma at the White House Correspondents Dinner that "No, the market did not get it right" after his recent comments.
Once again, the One & Done play was a sucker's trade.
What is this, the 4th or 5th time? Great Caesar's Ghost, even a puppy learns not to pee on the carpet after he gets rapped with a rolled up newspaper twice. These traders have been getting bitch-slapped around like they are Wile E. Coyote and the Fed Chair is the RoadRunner. Its astonishing that the same suckers keep coming back for the same abuse. Get some help, get into a support group for abused
This does go a long way in explaining the new Fed Chair Curse -- perhaps it takes a while before the Chairs learn they are not still in Academia or where ever; it took Greenspan a long time to learn to speak for 4 hours straight -- and say nothing. I suspect it may take Bernanke a little longer to learn the dark art of obsfucation . . .
Existing Home Sales Data (California Real Estate: On Sale!)
Sales of existing homes surprised to the upside yesterday. But one data point does not make a trend. This is the first rise (sequential monthly change) after 5 straight months of falling Home Sales. And that's before we examine the data.
Before you declare the end of the housing slow down, consider:
- Existing Home sales actually slipped vs. last year by -0.7%; The reported gain was over last month's data;
- the Inventory of unsold homes soared 7 percent in March, hittting an all-time record; There are now 3.19 million existing homes for sale, or 5.5 months' supply; That's the largest inventory since July 1998
- Existing homes edged up 0.3% last month to a seasonally adjusted annual rate of 6.92 million units; (we know that seasonally adjusted data is not always accurate)
- Year over year, the Northeast and Midwest gained, while the previously hot housing markets in the South and the West slipped;
- median home prices are still rising, albeit nmore slowly -- up 7.4% year over year, to $218,000.
Here's a data point that has me scratching my head: Why are there different numbers for the year-over-year changes for seasonally and not seasonally adjusted? Was this March somehow in a different season than last year's March? I am perplexed.
Note that data for existing home sales comes from National Association of Realtors, a group that is certainly an interested party; Of course, as a homeowner, investor, and someone with a public bearish tilt for the second half, I'm hardly objective myself (hey, I try). But this oddity -- down -0.5% for the not seasonally adjusted year over year versus down -0.7% for the seasonally adjusted year over year -- is beyond my comprehension.
So much for the hard data on existing sales; Today, we get New Home Sales. Recall our prior admonishments that monthly New Home Sales Data are unreliable; look instead to a moving average.
Let's move onto some anecdotal evidence. A friend writes:
"Flop! Wow, KB running blue light specials in California. Not surprising, Chico area was rated one of the most overvalued markets in the country. Houses in the $200k space. When was the last time you saw that in California? "
Here's the sales pitch:
"Oak Knoll Place in Live Oak is located in a beautiful community near the majestic Sutter Buttes. With easy access to Highway 99, it is ideally located for easy access to Sacramento, Lake Tahoe, Reno and a wide variety of recreational opportunities. Yuba City and Marysville are approximately 10 minutes south, Chico is approximately 35 miles north and the Gray Lodge Wildlife area is approximately 10 minutes west. Live Oak has a quaint, small-town atmosphere with many nearby recreational water activities, including the Feather River, Yuba River and Sacramento River. Prices starting from the High $200's."
I don't know Live Oak, but houses like that in California are hard to imgaine . . .
More after the jump.
Existing-Home Sales Rise Again in March
NATIONAL ASSOCIATION OF REALTORS
WASHINGTON (April 25, 2006)
NATIONAL ASSOCIATION OF REALTORS
Here's another example of price cutting on New Home Sales:
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Smackdown: Fleckenstein vs Yardeni
"Even if the Fed can't strip the inflation measurement of all items going up in price, it has a built-in excuse, provided recently by economist Ed Yardeni: One must decide whether prices are going up because of "excess demand" or supply disruptions. As Yardeni wrote in his morning piece April 11: "Raising interest rates when supply shocks may be the main reason for higher commodity prices could be a mistake, especially when there is no evidence that core-inflation rates are rising too."
His explanation: "Rising commodity prices resulting from supply disruptions -- rather than driven by demand -- may take the steam out of the global boom, and slow U.S. consumer spending and overall economic growth."
See? Rising prices will correct themselves if they're due to supply disruption, an argument that he leans toward. (Rising prices couldn't possibly come from too much money-printing, could they?) The Fed need do nothing. Thus, I believe (for not just this reason, but others that I have articulated) that only one more rate hike remains in the Fed's quiver.
That said, I still think we could see data that would persuade the Fed not to even give us that much. If there is a nasty sell-off into earnings season, if we do in fact see some negative economic data, coupled with problems in the real-estate market (none of which would shock me), the Fed might be inclined to stand down on May 10. Either way, the rally that we get when the Fed decides it's done will be the last one before serious downside action occurs.
Does the Fed really 'know' what’s going on?
MSN Contrarian Chronicles, 4/17/2006
One Last Comment on M3
We started beating the M3 drum back in November 2005. It seemed to us -- on the basis of the rapid increase in M3 versus M2 alone -- it was a worthwhile stat to keep around, and we could not understand why the Fed was so intent on cancelling M3 reporting. These perspectives were dismissed by some as paranoia.
You can imagine how pleasantly surprised we were when Raymond James' Jeff Saut addressed that very issue this morning:
"Yet, we just don’t “get it” because as the Fed has been raising interest rates, it has simultaneously been talking rates down by commenting on how “contained” inflation remains. Surprisingly, concurrent with the Fed’s financial tightening has been Mr. Bernanke’s “printing press” gone wild with roughly $1.5 trillion additional dollars per year being added to the country’s money supply, at least at the last M3 reading. And that caused one savvy seer to exclaim, “Can you spell liquidity?!” Liquidity indeed, for as Ed Hyman aptly notes, “U.S. Federal outlays in the 4Q increased to a remarkable $2.7 trillion. That’s 21% of GDP and increasing at a 30% annual rate.”
Suspiciously, however, one month ago those M3, broad-based, money supply figures ceased to be reported because they allegedly added little additional value to the M2 figures. Hereto “we just don’t get it” because M3 contained the amount of repo activity in the banking system while the M2 report does not. Repos, ladies and gentlemen, is short for repurchase agreements, which are contracts for the sale and future repurchase of a financial asset. Most often repos are used with Treasury securities. We think repo activity is pretty important since it shows the amount of “financial leverage” the Federal Reserve is attempting to introduce into the banking and brokerage system. Indeed, we just don’t “get it.”
Nevertheless, in this business what you see is what you get, which reminds us of that old Annapolis “saw” – you can’t change the wind, but you can always adjust the sails! And currently the “winds” are blowing interest rates higher. Where this rate-rise will end is unknowable. Even the Fed has hinted that it doesn’t know by commenting that things are “data dependent.” However, consider this – When was the last time the Federal Reserve stopped raising interest rates with many of the equity markets at (or near) all-time highs, base and precious metals at multi-decade highs, oil within “spitting distance” of record highs, and retail sales (despite a late Easter), as well as the housing figures, stubbornly perky? Furthermore, the recent unemployment rate was at a four-year low (4.7%), while the first quarter’s employment figures showed the strongest non-farm payroll growth in six years. Historically, rising employment growth has tended to lead to rising wage pressures. As the good folks at the GaveKal organization opine, “Once again, we find ourselves asking the question, can the Fed really stop at 5% in this environment?”
In addition to these questions, we would suggest that forgetting the laughable “core” inflation figures (ex-food/energy), annualizing last month’s headline CPI figure of +0.7% (core was +0.2%) yields an inflationary ramp-rate of 8.4% (0.7% x 12). While clearly one month does not make a trend, even if we use this week’s estimated headline CPI number of +0.4% (-0.2%E core), and average it with last month’s (0.7% + 0.4% / 2 x 12 = 6.6%), we get an annualized inflation rate of 6.6%. The potential inference from this is that despite the Fed’s “tightening campaign” with Fed Funds at 4.75%, overlaid with a 6%+ inflation rate, we could still be in a negative “real” interest rate environment. Given the possibility of still “free money” (aka negative real rates), no wonder speculation remains rampant in the various markets."
What more can we add to that?
The 5% Solution
Mortgages, Foreclosures & the Fed
The WSJ discusses one of the nasty side effects on Mortgages and Real Estate of rising rates and slowing real estate: Delinquencies and foreclosures:
"As home-price appreciation has tapered off and mortgage rates have risen, foreclosures have started to pick up, with the Midwest region hit hardest.
The rate of foreclosure -- the process by which banks can ultimately take back the properties that secure mortgages -- is a key indicator that real-estate analysts and investors use as a signal of market distress.
In the past several years, foreclosures across the U.S. have been hovering around historically low levels, as home prices have risen nearly 50% in five years. This appreciation enabled borrowers to sell their homes relatively easily to resolve mortgage difficulties.
Now, a survey of the latest data confirms, that is starting to change, with an uptick across the U.S. in foreclosure rates and mortgage delinquencies (or late mortgage payments). But even the new higher rates of foreclosure and delinquencies are still low in historic terms.
Nationally, the number of mortgage loans that entered some stage of foreclosure rose to 117,259 in February, up 68% from the same month a year earlier, according to Irvine, Calif., online foreclosure-data service RealtyTrac.
Delinquencies are up as well. Data provider LoanPerformance, a subsidiary of First American Real Estate Solutions, reported that 3% of the most vulnerable loans -- those made to borrowers with less than a stellar credit history -- were 90 days delinquent in February. That is up from 2.84% in February 2005. Meanwhile, 90-day delinquencies for loans made to borrowers with better credit were up to 0.76% in February, from 0.67% a year earlier." (emphasis added)
Getting the blame for the uptick in delinquencies is the "greater prevalence of riskier adjustable-rate and subprime mortgages, as well as higher interest rates and energy costs."
Surprisingly, the Midwest is the region with highest rates of loan foreclosures and delinquencies: the big three are Indiana, Ohio and Michigan. One must suspect the fallout from GM is to blame in part.
Then, there is the uptick in treasury yields. Higher rates are not a blessing in disguise --despite what you may have read by Charles "Whoopee-higher-rates-are-here-again" Biderman.
Foreclosures Pick Up With Midwest Hardest Hit
By DANIELLE REED
April 14, 2006; Page A8
Mortgage-Bond Market Stays Strong
WSJ, April 14, 2006; Page B5
As Markets Bet on Rate Increases, Fed Officials Seem Less Committed
April 14, 2006; Page A1
10 Year Yield: 5.043%
Quote of the day
"Home sales are in the process of reversing all the gains of the past two years and reverting to 2003 levels."
- Robert Mellman, economist, J.P. Morgan
The WSJ's Afternoon Report reports that mortgage apps sank 5.5% last week; According to the The Mortgage Bankers Association, applications for purchase fell 4.7%, while refis slid 6.6%.
Not coincidentally, borrowing costs ticked higher: the average rate on a 30-year fixed mortgage is 6.50%, while the one-year Treasury adjustable-rate mortgage rose to 5.97%. These are the highest rates have been since April 2001.
WSJ, April 12, 2006 12:34 p.m.
Then & Now
Over the past 3½ years markets crawled higher, we have watched the gradual but steady build up of bullish expectations. You can see it most plainly in the 2006 BusinessWeek forecasts. The majority of strategists, technicians and economists are expecting gains for the markets in 2006, ranging from mid-single digits up to as high as 30%.
In the Fall of 2002, you were hard pressed to find such sentiment. As telecom stocks bottomed, and profitable technology stocks sold for less than cash on hand, the Bulls were MIA. Telecom, tech and internet stocks, having so duplicitously betrayed their lovers, were widely despised.
It wasn’t only the sentiment that was different back then: Nearly every metric we track was in a different part of the cycle, and pointing in a different direction. Both the vector and angular momentum were different than at present. Consider each of the following:
Interest Rates: In 2002, bond yields were low and heading lower. Since then, bonds have worked their way lower sending yields considerably higher – and they’re heading even higher still; (See nearby Yield Curve charts);
Inflation: The Fed reflated the economy, but awoke inflation. 3 years ago, prices were stable; the big fear was deflation. Today, prices for goods and services are rising.
Earnings Growth: Year-over-Year earnings were awful in 2002, with easy comparisons, and nowhere to go but up. Today, with comparisons much harder, earnings growth is a the top of its range, and is more likely to decelerate;
Fiscal Policy: The Deficit was modest; Federal taxes, especially those on dividends and capital gains, were being cut. Today, rates are more likely to rise than drop. Taxes at the State and local level have been creeping higher;
Real Estate: was beginning a historic growth spurt with major economic impacts: it created 42% of new private sector jobs, allowed mortgage equity extraction of $2 trillion dollars, and drove massive consumer spending – and GDP. Today, at best RE is cooling down; At worst . . .
Consumer Debt: was problematic, but manageable. Now, the negative savings rate combined with significant increases in mortgage debt are extremely concerning.
Commodities: Oil was under $30 and exerted little drag on consumer spending or transport costs; Industrial Metals were cheap, Gold and Silver were half their present prices.
The macro environment, despite the negative sentiment – or more accurately, in large part, because of it – was far more attractive three years ago than it is today.
Note: This was part of a larger research piece that was emailed to institutional clients on April 11, 2006 at ~10:00am
Chart of the Week: Yield Curve, 2002 versus 2006
In 2002, the Yield Curve was extremely steep, with short term rates at half century lows. This was extremely stimulative to economic growth. Money was cheap, the carry trade was in full swing, and the Real Estate market was just beginning to accelerate.
Yield Curve, 2002 versus 2006
In December, the yield curve was inverted, and today, it is flat. The Fed finally got its wish, with the long bond responding to increased Fed Fund rates. We wouldn’t be surprised if the curve ends up steepening as traders sell the longer dated bonds.
Quote of the Day:
“To know values is to know the meaning of the markets.”
Note: This was part of a larger research piece that was emailed to institutional clients on April 11, 2006 at ~10:00am
Did the Yield Curve Send a "False Alarm?"
"So much for the inverted yield curve."
Or so says a recent Bloomberg column. If I read this correctly, any inversion that fails to cause an immediate recession is proof positive that inversions are meaningless, the bond market clueless, and data analysis of little if any value. Therefore, as an economic indicator, this must be declared null and void and immediately disposed of.
"Bond yields may have sent a false alarm. The government said today that U.S. employers added 211,000 jobs in March, capping the best start for hiring of any year since 2000. Gross domestic product last quarter probably expanded at a 4.7 percent rate, the fastest in more than two years, a Bloomberg News survey shows. The Federal Reserve is talking about the need to keep raising interest rates to make sure the economy doesn't overheat."
Let's reiterate some of our prior comments about the yield curve, and what it means for investors:
"A brief, shallow inversion won't signal any marked slowdown in the economy.
Over the past several decades, the yield curve has had to invert by two percentage points or more before a recession materialized."
The longer and more inverted an inversion is, the greater the slowdown it forecasts. A short, shallow inversion is a warning; The longer it stays inverted, the greater the impact. There is a nuance to the curve that seems to be getting overlooked.
Second, Yield curves do not take place in a vaccuum. The context and other factors involved need also to be considered, such as energy prices. And to reiterate this yet again, one needs to consider at all times multiple variables when analyzing Markets. The context of rising oil prices and inversions is important (see the charts here for more).
Its worth pointing out that the yield curve is actually more than one variable; its a combination of two factors:
First, Short interest rates, which reveal the Central Bank's economic expectations.
And, second, its a function of long rates, which embodies the Bond Market's economic expectations.
As we quoted in December:
"The historical record speaks for itself," said Merrill Lynch analysts in a report published Friday.
"In the past 30 years, the yield curve has inverted five out of the eight times the Fed has been tightening monetary policy. Each of those five times an economic recession has ensued one year later -- our fear (though not our base case) is that this time will be no different." - Marketwatch
That's a year later -- not 90 days. If you want to be even more precise, the historic lead time is 40 weeks prior to a slowdown.
Lastly, consider this chart:
(previously shown in September '05)
click for larger graphic
The data looks fairly persuasive that any inversion is worth noticing, and that a longer deeper one is a broad warning sign that investors ignore at their own peril.
Yes, we live in a bumper sticker society, where nuanced is scorned, sound bites rule, and careful contemplation is a rarity. That doesn't mean we all have to succumb to the philistines . . .
Yield Curve Sent False Alarm as U.S. Economy Expands
Bloomberg, April 7, 2006 09:44
Understanding the Inverted Yield Curve
August 20, 2005
Does the US have a "Credit Risk Spread" vs Other Nations?
Why have yields on US Treasuries been so much above other nations?
I am not referring to the recent spurt on the 10 year towards 4.98%; Rather, I am referencing the generally higher yield on US Treasuries versus other westernized nations (UK, Canada, Germany, Japan).
In the past, we have seen this spread occurring in periods of elevated US risk:
Justin Lahart notes the impact of the dollar on this process:
"U.S. stocks are getting repriced versus foreign stocks. Between 2002 and 2004, this rebalancing happened largely because the value of the dollar was declining, dragging down the value of U.S. investments. But last year, when the dollar rallied, it was through relative stock prices. U.S. stock markets simply couldn't keep up with rivals abroad.
The same can be said of the bond market. Last year long-term U.S. Treasury securities underperformed long-term government bonds in Europe and Japan. Because bond yields move in the opposite direction of their prices, that's another way of saying that U.S. interest rates rose relative to their overseas counterparts. Today, the yield on a 10-year U.S. Treasury note, 4.79%, is higher than yields in places like Germany, the U.K. and Japan . . .
The good news here is that Treasury bonds now provide overseas investors with better yields and U.S. stocks look cheaper relative to overseas stocks. That helps to keep attracting foreign capital. The bad news, says Mr. Prince, is that the repricing isn't finished.
I am not sure its purely a currency issue, since it seems to persist regardless of whether the greenback is rallying or taking a dive. As the chart at top shows, it often peaks near an "event."
I'm curious if the yield has anything to do with the geopolitics of Iraq, our twin deficits, or something else entirely.
AHEAD OF THE TAPE
March 29, 2006; Page C1
Macro Impact of Rates
I mentioned in the prior post that higher rates impact consumers in a negative fashion; Let's look at some additional details, and respond to some bad dope on this.
There has been a meme circulating, attributable to Charles Biderman of Trimtabs, that the overall impact of rising rates is a net positive to US Households. MSN's Jon Markman described it thusly:
Here's the math: Households held $6 trillion in cash, savings accounts, and certificates of deposit with maturities of less than one year at the end of 2005. The interest earned on all of that paper is at least one percentage point higher this year than 2005 and two percentage points higher than in 2004. As a result, says TrimTabs, consumers will receive $61 billion more in income from higher short-term interest rates this year than in 2004. That's real money they can spend on clothes or cars, and invest in stocks.
That's the upside of higher rates. The down side? Trim Tabs estimates that $836 billion in adjustable-rate mortgages will reset this year. If the average increase in adjustable mortgage rates is 2.5 percentage points, then higher interest would only cost consumers $21 billion.
First, that omits all the other variable debt obligations -- most especially credit cards.
Second, and perhaps more importantly, there seems to be some confusion here between median and mean (with issues of distribution and dispersion). This is not the first time I have noticed this habit out of Trimtabs.
This issue is easily resolved for the typical family: How much variable debt obligations does your household have? Have much variable income bearing instruments does your household own?
Add 'em both up. If your monthly/quarterly debt obligations are greater than your interest income , rising yields hurt you; If you have less, they help you.
Where Biderman's analysis loses touch with reality is his explicit statement that because ALL American households have more cash/CDs/bonds/etc than they do have debt, rising yields helps them!
Technically, that specific statement is true -- but its also terribly misleading. When you see how those interest bearing income instruments are distributed across the US, its apparent that a big percentage of households are hurt by rising yields. The prime beneficiaries are the very wealthy -- and retirees living primarily on yield -- assuming they are laddered, have CDs and savings accounts, and are not rate locked.
For most American families, however, rising Yields are burdensome. The impact is likely to be felt in retail spending.
Addendum: In one of those wonderful pieces of irony that you couldn't make up if you tried, the Director of Public Relations for Trimtab is named Puffer; (How great is that?) That's even more appropriate in light of their cheerful reading of data.
How higher rates pad our wallets
MSN Money, Wednesday, March 29, 2006
NFP lifts Yields & Spooks Stocks
Don't say you weren't warned.
Yesterday's NFP data was only slightly warmer than consensus -- 211k vs 200k -- but it was enough to push the 10 year yield up to nearly 5%. That was enough to scare equity holders out of their longs, and drive the Dow down almost 100 points.
The 5% yield is obviously troublesome from a macro perspective; Higher fixed income yields attract investment dollars while simultaneously making operating costs higher for corporations.
Higher yields also pressures those consumers who have variable debt obligations -- credit cards and adjustable mortgages. And you can just about forget HELOC/Cash out refis for the near future.
Let's address a few data points that have bveen released lately that may be in need of some further explanation:
1) $16.49 is the average hourly wage for production worker, who are about ~80% of the work force. That's a monthly gain of 0.2% (February was revised to +0.4%)
2) Hourly pay is now 3.4% than 12 months ago -- that increase fails to keep up with the inflation rate
3) But Wage improvement has accelerated in 2006. Compare an annual 2.3% rate 6 months ago versus 3.7% today; The WSJ noted "it's the first time since June 2005 that production workers saw their weekly pay rise above inflation." This explains all the recent Fed fears -- and yield gains;
4) The total number of new hires reflect both organic growth and Katrina relocatees finally showing up in the data;
5) Hours worked ticked up, after sliding for a while. However, many of these hours are not paid work -- they reflect (in part) non-compensated overtime; They may be less inflationary than assumed;
As you can see, NFP and the details beneath are a bit more complex than just the headline number.
Payrolls Increase at a Healthy Pace Companies' March Hiring
Hints at Upward Pressure On Inflation and Wages
April 8, 2006; Page A3
Real Fed Fund Rates
Last week, we looked at the historical range of Federal Reserve Funds since 1946.
It was a simple mean reversion, and did not incorporate the post WWII price controls, the 1970s inflation spike, or the Bretton Woods agreement.
As such, some implied that it overstated Fed Funds rate. Marketwatch's Rex Nutting had the suggestion that it would be instructive to look at real versus nominal Fed rates (see update 2).
After the Fed meeting, Rex did just that, and analyzed the real (after inflation) Fed Funds Rate. His conclusions?
"Adjusted for the increase in the consumer price index, the real federal funds rate has averaged 1.75% since 1956. Currently, the real rate is about 1.10%, with a fed funds rate of 4.75% and a trailing inflation rate of 3.65%.
To bring rates back to the 50-year average, the Fed would need to raise rates or lower inflation by a cumulative 0.65%."
Ahhh, but that's a simple mathematical exercise (like ours) that does not consider all the variations in economic time periods -- including periods of "low inflation and modest growth, times of high inflation and no growth."
Which raises the obvious question: What has the Fed Funds Rate looked like in similar periods of high productivity and high growth?
"The Fed achieved a soft landing in the economy in 1995. From late 1994 through mid-1998, the Fed managed to keep the fed funds rate relatively steady between 5.25% and 6%. The economy prospered, growing at an average rate of 3.7%. Inflation averaged 2.5%.
During that time, the real fed funds rate averaged 3.1%, two full percentage points higher than today.
This analysis suggests that, in a period of high productivity and high growth, it may take a somewhat higher real funds rate to keep inflation low.
If the Fed wants a 3.1% real funds rate, it might have to boost nominal rates another 2 percentage points to 6.75%. The Fed probably wouldn't have to do all eight quarter-point hikes, because that much tightening would probably have some impact on lowering the inflation rate (otherwise, why do it?).
If inflation rates moderated to 2.5% or so under the pressure of Fed tightening, the Fed could probably stop at 5.50%
That's my number (as well Lehman Brothers). To get there requires three more 1/4 point hikes.
As to that soft landing, I would point out that the 1995 was a period in the middle of a secular Bull Market. Technology, networking and computers were the prime drivers, creating a virtuous cycle that powered the economy and markets higher. It was an organic business cycle expansion that kept going until it reached an upside blowoff in Spring 2000.
That is quite different than the present stimulus driven economy. The Fed's tools are not being used to moderate this hot economy; Rather, they are slowly removing the economic stimulus namely, pulling interest rates up from 46 year lows.
Those are the prime differences between 1995 and 2005: a secular bull market driven by organic economic expansion, versus an economy that has been driven purely by a combination of government (war spending, tax cuts, deficit spending) and Monetary (rate cuts, increased money supply) stimulus.
Monetary policy still far from normal
MarketWatch, 8:24 PM ET Mar 28, 2006
Famous Last Words
Barron's notes that while Bernanke did not utter those four special words, the meaning of his speech this past Monday essentially said the same thing:
IT'S DIFFERENT THIS TIME. No four words have been more costly to investors, whether they referred to tulips or dot-coms. And the greater the intellect behind each new theory, the more likely it will come a cropper. After all, it takes a certain genius to make a case for Dow 36,000.
Ben Bernanke had his coming-out party last week, giving his first big speech as Fed chairman to the Economics Club of New York. And for that hip crowd, he chose an equally scintillating topic, the yield curve...
The yield curve is the current hot topic, especially since the puppeteers at the Fed have been yanking up the short end for going on two years while the long end has drooped. The curve, as aficionados refer to it, is pretty much a straight line around 4.65% to 4.70%. The new Fed head offered several explanations of why that might be: Inflation's low and expected to stay that way, just as in the 'Fifties and 'Sixties; the level of "real," or inflation-adjusted, interest rates has moved down a notch, or there is a global glut of savings and not enough investment to mop it up.
Bernanke also suggested what the yield curve didn't mean -- that the economy was about to slow, or worse, head into recession. No matter that every economic contraction has been presaged by a flat or inverted yield curve (that is, higher short-term than long-term rates, the inverse of the usual shape). This time is different, the former Princeton professor argued, and apparently persuaded much of the crowd.
Not Northern Trust's Paul Kasriel, however. He points out that back in those Happy Days of low and stable interest rates, the August 1957-April 1958 and April 1960-February 1961 recessions both were preceded by flat but not inverted yield curves. Real short rates were even negative going into the '57 downturn, so the Fed wasn't exactly turning the screws real tight.
A flat to inverted yield curve isn't so much a cause as a symptom of what's happening in the credit system. Investors are willing to lock up money for a decade or more without getting paid any extra only because they think short-term rates are going to fall in the future.
Other symptoms? Housing rolling over, high Oil prices, protectionist politicians, and my personal favorite, explanations for why its different this time . . .
Famous Last Words
RANDALL W. FORSYTH
Barron's MONDAY, MARCH 27, 2006
Fact-Checking Bernanke’s Yield Curve Comments
Paul L. Kasriel
Northern Trust Global Economic Research, March 21, 2006
10 Year Yield Makes a Run for 5%
Barron's Michael Kahn makes the case that the line in the sand for equities is the 10 Year Bond's Yield is at 5%; Breaking out over that -- a move that appears imminent by the next 2 Fed meetings -- sets up a possible market break in stocks -- not the denouement -- but a definite sharp sell off.
"With the intermediate-term trend rising and resistance from the long-term trendline still well above the current market, it means that there is little on charts to get in the rally's way.>
Let's go to the chart:
Chart courtesy of Barron's Online
"The charting textbooks tell us that a rising trend that pushes through resistance levels is likely to continue rising. Whatever negative pressures by interest-rate bears (or positive pressures by bond bulls) at 4.682 have been overcome.
So, where can interest rates go, now that resistance has been broken? For that, we turn to long-term charts and see that the trendline from the peak in interest rates in 1994, when the 10-year was over 8%, is now coming into view from above. What that means is that the rate for the 10-year can rise to 5% over the next few weeks without officially ending the major bear market in yields."
Once again, to the chart:
Longer Term Chart: 10 Year Treasury Bond Yield
Chart courtesy of Barron's Online
Watch that line at 5% -- a breakout over that is where things get dicey:
"If we assume that the relationship between stocks and interest rates has returned to what it used to be -- rising rates being bad for stocks -- then this does not bode well for the stock market in mid-2006.
A weaker economy in the near future is certainly something that will also pressure the stock market today, as the stock market reacts to what it sees coming, not to what is happening now. In other words, if a recession is coming, then the stock market will weaken before the economy does.
All told, the bond market is now giving off ominous signals for the stock market, but not the end-of-the-world indications the staunchest of the bears might think. If the long-term interest rate trend is broken and rates rise significantly above 5%, then we'll need a major rethink. But we'll cross that bridge when we get to it."
This is very consistent with our prior warnings as to why inflation is so bad for equities . . .
Rising Bond Yields Will Pressure Stocks
Barron's Wednesday, March 8, 2006
New Homes Sales: 4th Drop in 6 months
No surprise here:
"New-home sales fell for the fourth time in six months during January, while inventories climbed to another record.
Sales of single-family homes decreased 5.0% to a seasonally adjusted annual rate of 1.233 million, the Commerce Department said Monday. December new-home sales rose 3.8% to a seasonally adjusted annual rate of 1.298 million; originally, December sales were seen at 1.269 million. Sales dropped 7.0% in November, rose 7.7% in October, and sank 2.0% in September and 7.1% in August.
Analysts say the housing sector is cooling after years of record-breaking demand. This view has held despite an earlier report showing January home construction climbed to a 33-year high. The surge in housing starts was attributed to weather -- it was the warmest January on record in the U.S., with an average temperature of 39.5 degrees.
January new-home sales fell 10.8% in the Midwest, 14.9% in the Northeast, and 10.3% in the South. Sales climbed 11.3% in the West."
There were an estimated 528,000 homes for sale at the end of January, which was a record. That represented a 5.2 months' supply at the current sales rate, the highest pace since 5.2 in November 1996. In December, an estimated 515,000 were for sale, a 4.8 months' inventory. An estimated 93,000 homes were actually sold last month, up from 89,000 in December, based on figures not seasonally adjusted."
The key takeaway to me is that Inventory to sales ratio is now at a 9-year high -- 5.2 months while the number of units for sale at a new record. The Affordability Index shows homes are at 15-yr. low.
courtesy of Calculated Risk
Sales of New Homes Fell By 5% During January
WSJ, February 27, 2006 10:09 a.m.
NEW RESIDENTIAL SALES IN JANUARY 2006
FEBRUARY 27, 2006 AT 10:00 A.M.
Manufacturing and Construction Division
Further Yield Curve Inversion "a Given"
Or so says the Treasurys team at Jefferies & Co. in New York.
I cannot say I disagree. The 10-year Treasury is looking to trade between 4.48% and 4.62% this week.
Further, with at least one and likely two and possibly three and an outside chance of four more Fed Reserve tightenings, the curve is likely to invert further:
"Market participants are having an easier time swallowing the idea that short-term rates are likely to remain higher for a while than longer-term ones. Some participants have said they expect this aberration, known as a yield-curve inversion, to last for the rest of the year.
Late Friday, the two-year Treasury was yielding about 0.12 percentage point more than the 10-year Treasury and 0.15 percentage point more than the 30-year Treasury.
The Treasurys team at Jefferies & Co. in New York said further inversion of the yield curve is basically a given.
That is because government sales of $22 billion of two-year Treasurys tomorrow and $14 billion of five-year Treasurys Thursday will likely add pressure to those maturities and send their yields higher. Month-end buying by longer-term investors who need to match their portfolios to extensions in benchmark indexes will likely support 10- and 30-year maturities and send those yields lower."
Treasurys May Remain Steady As Yield-Curve Inversion Persists
WSJ, February 20, 2006; Page C10
In Long-Term American Treasury Securities They Trust
What does it mean when so many overseas investors -- governmental, corporate, and institutional -- are hungry for US paper?
There are a variety of potential explanations: Yield is relatively attractive here, its a safe investment for those looking to move cash away from their native countries. For exporters, buying US Treasuries helps pressure rates down, thus financing additional consumer spending. Floyd Norris writes: "The vast majority of foreign Treasury purchases came from private foreign investors, who presumably were attracted by the yields and by the fact that the dollar gained in 2005 against the Japanese yen, the euro and the British pound, while falling less than 3 percent against the Chinese yuan."
The United States is politically stable (despite red/blue divisions); Nor does it hurt that we have an unblemished track record of paying our sovereign debts -- even with all of the economic imbalances of recent years or the past.
Here's what the past 3 decades of foreign purchases looks like:
click for bigger graph
Here's the details, via Norris:
"GUESS who's financing the budget deficit of the United States? Hint: Very few Treasury securities are being purchased by American consumers or businesses.
The federal government released its calculations this week on net investments in United States long-term securities, and found that foreigners had invested $350.8 billion in Treasury bonds and notes in 2005. They were net sellers of short-term Treasury bills, so their total Treasury holdings grew by just $290.9 billion.
Even so, the United States Treasury says that Treasury securities held by the public — that is, by everyone except the Federal Reserve System and other arms of the government — rose by $306.4 billion. That means that 95 percent of the deficit was financed overseas.
Actually, foreigners are becoming a little less generous. In 2004, they bought $357.8 billion of Treasuries, 98 percent of the growth in outstanding Treasury securities. Over all, foreign investors bought a net $1.05 trillion in long-term American securities in 2005, the first time the number had gone to 13 figures. That was up 14 percent from 2004.
The gain last year showed increasing foreign trust in American corporations. While United States government and agency securities got most of the money, the increase largely came from a greater willingness to buy corporate bonds and stocks. Foreigners put a net $391.7 billion into corporate bonds, 27 percent more than they had invested the previous year and the largest amount for any year on record."
Let's hope they don't change their collective minds anytime soon . . .
In Long-Term American Treasury Securities They Trust
NYT, February 18, 2006
The Risk to Equities from Rising Rates
If risk-free returns on CDs have been returning performance equivalent to risk-laden returns on S&P500, the question some investors are asking themselves is "Why take the risk?"
That's the issue Justin Lahart explores (inadvertantly) when exploring the issue of how low rates actually are:
"Even though the Federal Reserve has been raising rates since June 2004, they're low historically. Over the past 50 years, the fed-funds rate (the main overnight rate the Fed controls) has averaged 5.75%. Today's [4.5%] hardly seems onerous . . .
Ed Hyman, chief economist at research firm ISI Group, points out that those low, long-term yields are also a signal that returns on other investments are expected to be low.
Consider stocks. Last year, the S&P 500 index had a total return (including dividends) of 4.9%. Meantime, the average rate on a six-month certificate of deposit was 4.6% in December. They're so close, you can imagine investors socking a bit more money in (safer) CDs and a bit less in (riskier) stocks.
These low expected returns have ramifications on economic prospects. It gives companies less reason to spend money on the equipment or new hires to expand. It gives venture capitalists less reason to fund budding businesses. In short, it discourages investment, and makes economic growth harder to come by as a result.
Today's low short-term rates may be plenty high."
Interesting stuff . . .
AHEAD OF THE TAPE
By JUSTIN LAHART
January 11, 2006; Page C1
Chart of the Week: 10 year Treasury 1974-2006
Greenspan garners all the credit for the low interest rates of the past 20 years. We believe the chart below proves otherwise. The Oil shock in the 1st half of the 1970s gave way to inflation shock of the 2nd half.
Source: RCP, Economagic
When Volcker was appointed Fed Chair, inflation was in the double digits and growth was stagnant. He forced unpleasant medicine down the gullet of the American economy, limiting the growth of the money supply and abandoning interest rate targeting. Inflation, which had peaked at 13.5% in 1981, was down to 3.2 percent by 1983.
Quote of the Day:
“A wise observer of the economic scene once commented that ‘what can be left to later, usually is – and then, alas, it's too late.’”
-Paul Volcker, Federal Reserve Chairman, 1979-87
When the yield curve inverted late last year, some commentors claimed that the media made too big a deal of the 2 year bond yield slipping over the 10 year. We've had numerous commentaries on the subject (but especially note these two December posts here and here).
Hmmmm, if everyomne made too big a deal about the 2/10 inversion last year, I wonder what these people think about Wednesday's inversion of the 3 month/10 year bonds? I noticed an utter lack of response by the media or investors.
Here's an excerpt from a well buried WSJ article on the subject:
"For the first time in more than five years, the yield on three-month Treasury securities ended the trading day above 10-year yields, a reversal of their traditional relationship. The phenomenon is known as an inversion of the yield curve, which has often signaled economic downturns."
. . . In late trading [Wednesday], the yield on the three-month Treasury bill stood at 4.356%. The 10-year note gained 1/32, or 31 cents for each $1,000 in face value, to yield 4.336% -- or 0.02 percentage points less than the 3-month bill. The 30-year bond gained 1/32 to yield 4.515%.
The flip in three-month and 10-year rates is significant because some analysts and economists see it as a more reliable indicator of future economic activity than other measures of the yield curve, such as the difference between two-year and 10-year yields . . .
The Federal Reserve Bank of New York, for example, used the difference between three-month and 10-year rates to build a model of the historical relationship between the yield curve and recessions. According to that model, the present level of interest rates suggests about a 25% probability of recession within the next year. Since 1960, recessions have always followed sustained inversions of greater than 0.12 percentage points. In early trading yesterday, the three-month yield rose as much as 0.05 percentage points above the 10-year."
Bond Market Cranks Up Alarm But Many Investors Just Shrug
THE WALL STREET JOURNAL, January 19, 2006; Page C6
Bill Gross Bond Timing Tool
In his January commentary, uber-bond manager Bill Gross shows a favorite chart he uses as a bond market timing tool:
This series of graphs is used by PIMCO to indicate when enough is enough - "the point at which adjustable short rates rise sufficiently to make the economy, cry "no más!" That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears."
Note the distinction between this chart and the yield curve:
"For sophisticates, please note that this is not the same thing as a flat yield curve. A flat yield curve is a concept comparing current short rates to current 5- and 10-year rates.
What my chart does is to compare current short rates to the Treasury’s average intermediate term "coupon," a more reliable and indicative indicator of economic pain or restrictiveness since it uses an average embedded cost of debt concept instead of a current cost. The standard flatness as measured by current market rates in early 1995 (not shown here) never led to a recession, only a slowdown, just as Chart I would have indicated. In other words, this indicator called for a mild slowdown in 1995 which is what we got.
The standard flat curve theory called for something more extreme which is something we never got. The embedded cost of debt indicator, therefore, shown in Chart I, has been more reliable."
Gross' conclusion? A US recession and a Bond market rally:
"The current data point in Chart I is not only calling for an end to the bear bond market, but a recession at some point 12-18 months hence. . . Hopefully you can take solace from a new timing indicator that says the worst is over for bonds"
That's consistent with my own views on the matters, but via a very different methodology . . .
A Gift That Should Keep on Giving
Bill Gross | January 2006
Read it here first: The World Isn't Flat, but Its Yield Curve May Be
Earlier this week, we brought to your attention "A World of (mostly) Flattening Yield Curves."
"But there are signs that the United States no longer has a monopoly on the conundrum. In recent months, the yield curves in Japan and Germany, the second- and third-largest economies in the world, have been flattening, while the yield curve in Britain has already inverted. "Long-term interest rates are even lower in Europe and Japan than they are in the U.S.," said Kenneth Rogoff, a professor of economics at Harvard.
Yet these economies lack some of the structural features of the United States economy. And each is at a different phase in the business cycle. While America may very likely have a slowdown in growth in the second half of this year, Mr. Rogoff says, Europe and Japan are likely to gain economic strength as the year progresses.
"The conundrum is global," said Lakshman Achuthan, managing director at the Economic Cycle Research Institute, based in New York. The same factors that are influencing the interest rate climate in the United States are having similar effects on overseas bond markets."
Of course, no discussion of Yield Curve flattenings or inversions would be complete without a graphic:
click for larger graphic
courtesy of NYT
I will point out that these curves are not as flat as the ones Panzner created, using the 2 and the 10 year Treasuries. (Dan, what duration are the treasuries used for the NYT charts?)
UPDATE: January 9, 2005 5:58am
I somehow missed the legend at bottom -- The NYT chart show the full yield curve for the entire maturity (3 months outward), versus our prior chart showing the spreads between two and 10 year maturities over time.
The World Isn't Flat, but Its Yield Curve May Be
NYT, January 8, 2006
What Worries Bill Gross . . .
Pimco's Bill Gross is nervous:
1) The current rather mild U.S. recovery has been driven by asset appreciation/consumption and not employment or capex growth.
2) Future growth is dependent on additional asset appreciation in real estate and stocks if Asia continues to absorb much of our investment and many of our jobs.
3) Recent asset appreciation has been set ablaze by several fiscal/monetary pumps displayed on page 2 with 5-year real rates being the central driver/gasoline can.
4) Tax cuts are a thing of the past and 5-year TIPS yields can theoretically decline only 60 basis points or so more.
5) The reason why intermediate/long TIPS have an interest rate floor is that if we approach potential deflation, investors risk losing money on a government guaranteed investment. The same concept applies to homes, stocks, and other inflation-adjusting assets without government guarantees.
6) The Fed may soon be out of fuel, despite hints of Bernanke-style helicopter money. Stocks and houses are already at low yields and high prices reflective of European economies nearing Japan-style liquidity traps.
Bill Gross | July 2005 http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2005/IO+July+2005.htm
The Fed announced their plans today to “only invert the Yield Curve somewhat,” rather than the deeper and more extensive inversions some traders feared.
The minutes revealed a debate between the two camps: The Hawks wanted to invert the Yield curve extensively, while another, more dovish group only wanted to see the flat curve inverted more moderately.
UPDATE: January 4, 2005 6:13am
Front page WSJ article states "Fed officials are less worried about inflation and thus may be nearing an end to their campaign to raise rates, minutes of their December meeting suggest."
Joanie has a very different take on both the minutes and the markets reaction:
"I read it in its entirety. Quite boring, as a matter of fact; nothing new at all.
They say that the economy is on solid ground across the board, the only slight slippage mentioned at all was a mention of a bit of cooling in housing. Employment and output are right up there and inflation, of course, remains in check.
The minutes go on forever, rehashing a lot of stuff we have known for eons. Some think we need more tightening, but there is no consensus as to how much. Bottomline, they are monitoring the data carefully. And will act accordingly.
Look. We knew all that; a couple or so more and finito. I found the minutes totally uninspiring and lacking in any detail that is not already well hashed out in the press.
HOWEVER: The tape says that they were dovish.
But here’s the biggest question of all: It took me a solid 20 minutes to read that junk all the way through as it doesn’t quite read as easily as the Daily News. So can you please tell me how they put the pedal to the metal at precisely 2 p.m.? I mean, you couldn’t even get on the website to read it that fast.
Bottomline: Earlier, we came within .30 of putting in a Oitside Down Day. They rallied here because they could. The minutes are the excuse."
A World of (mostly) Flattening Yield Curves
Many commentators have cited foreign buying of longer-term treasuries as the reason for this "conundrum." While the U.S. yield curve has flattened considerably since its August 2003 peak,that period hardly marks the beginning of foreign purchases of US Treasuries.
Further, if we take a fresh look at curves elsewhere, we see this issue is not limited to the U.S. As the chart below reveals, Yield curves around the globe are flattening.
While numerous rationales try to explain away the US inversion as an anomaly, the excuse making ignores the small fact that the US is not the only country with a flattening Yield Curve: So too are Japan, UK, Germany, Switzerland, Canada and Australia.
The yield curve inversion naysayers have yet to explain how foreign purchases of U.S. Treasuries are flattening curves elsewhere also.
click for larger graph
Source: Mike Panzner, Rabo Securities
Funny, those who try to convince you the Yield Curve doesn't mean anything aren't mentioning this inconvenient factoid of Global Curve Flattening.
To paraphrase Panzner: "Given that spreads between long and short-term rates in many major bond markets (including Japan) have also fallen recently, perhaps "this time" is not so different after all? Could it be that global bond markets are anticipating an impending slowdown?"
Here's a typical set of explanations:
1) stock-market investors fled the crash of 2001, and their alternative-investment strategies have soaked up the supply of bonds and other fixed-income securities.
2) China and other Asian countries are parking their dollars to drive up the value of the U.S. currency and keep their export-driven growth booming.
3) U.S., European and Japanese populations are aging, and with age comes an investment preference for security and income.
4) prices for everything except fossil fuels are being held down by productivity increases, international competition and excess manufacturing capacity.
-Peter Morici, international economist at the University of Maryland's business school
At first blush, these all appear reasonable. However, a closer look reveal the flaws in each of these explanations:
1) This is belied by the enormous amount of cash and cash equivalents -- trillions of dollars in money market accounts -- hardly equates to "soaking up bond supply;" And, the crash began in 2000;
2) Foreign buying of US bonds cannot explain flattening yield curves elsewhere (See chart above);
3) True dat; Now what about the very young populations in the rest of Asia and the Middle East? Or do we just pretend they are not market participants, and ignore the fact their equity markets have all soared in 2005?
4) Astonishingly misleading statement: Nothing is going up except oil? How about food, building materials, education costs, industrial metals, healthcare, raw goods, insurance, housing, precious metals -- they all have risen dramatically.
While most goods have gone up in price, while a handful of items have come dwn. When we talk about electronics, note that the mechanism that brings their proces down is an economy of scale. The first few units are prohibitively expensive, essentially paying for the factories. The next wave are some what cheaper, and by the thrid iteration, they become mass produced and much less expensive. Think Plasma screens: They have all plummeted in price -- excepting, of course, for the one screen that I want.
For the numbers geeks, here are the actual changes in the 10-year vs. 2-year government bond yield spreads for selected countries since August, 2003 (which was the most recent major peak, based on weekly data, in the U.S. spread):
UPDATE 1 JANUARY 6, 2005, 1:31pm
Check out this Sunday's NYT for more on this phenomena . . .
UPDATE 2 JANUARY 8, 2005, 8:31am
This is in today's Sunday NYT
The World Isn't Flat, but Its Yield Curve May Be
NYT, January 8, 2006
Michael Panzner, Rabo Securities
THOMAS G. DONLAN (Editorial Commentary)
Barron's, MONDAY, JANUARY 2, 2006
citing Peter Morici, international economist at the University of Maryland's business school
2 Studies on the Flattening Yield Curve
A reader asked about prior studies on a flattening or inverting yield curve, wondering "what have they concluded?"
Quite a few other analysts have looked into the question. Here are two worth considering:
Bill Gross, who manages the world's largest Bond fund -- and therefore better know about this stuff -- featured the chart below last month.
Gross' conclusion? "By the time 10-year and 2-year Treasuries reach parity, as is almost the case now, the economy is typically slowing and the Fed is at or near the end of its tightening cycle."
Here is his relevant chart:
click for larger graphic
Courtesy of PIMco
Gross also observed that "Economists/investment managers are aware of the potency of a flattening yield curve (shown in Chart above). . . Only [former Fed Chair] Volcker, with his need to strangle inflation out of the system, persisted into negative yield curve territory for longer than a few months."
Further, I happened to come across this commentary -- A Study on the Flattening Yield Curve -- of post-1970 inversions.
The study's generalized conclusions?
- Recessions have been preceded by yield curve inversions since 1970.
- lead time averages over 40 weeks.
- The S&P 500 does not do well when the yield curve is inverted (performance measured over the entire span of the inversion).
The chart accompanying that commentary shows yield curve inversions relative to the S&P500.
See the rest of the charts form various studies here.
UPDATE: December 29, 2005 1:30PM
I have made repeated references to never relying upon one lonesome single indicator, burt some of the newer reader smay have missed them. For those of you haven't done so yet, please see Single vs. Multiple Variable Analysis in Market Forecasts . . .
UPDATE 2: December 29, 2005 3:03PM
Dave Altig of MacroBlog fame suggests NY Fed's Arturo Estrella yield curve primer: The Yield Curve as a Leading Indicator. Its another excellent (if somewhat jargon laden) source.
Takin’ It To The Blog
PIMCo Investment Outlook, November 2005
Explaining Yield Curve Inversions
The Yield Curve briefly inverted -- twice -- Monday. As we noted yesterday, the deeper and longer a curve remains inverted, the more potentially significant it is.
That factoid has been overlooked by many commentators. Following yesterday's post about what an inversion means, it became apparent that there is alot of confusion about the implications. So far, all we have is a brief inversion -- which, for the moment, is merely a warning.
The best explanation I've read for what the Inverted Yield Curve may mean to the economy and markets comes from Lacy Hunt, a veteran Wall Street economist who formerly worked at the Dallas Fed:
"There has been a lot written about the flattening yield curve, though most people don't understand what causes it.
The narrowing spread between yields is a superb leading indicator but shouldn't be observed in a vacuum -- no lone silver bullet can take down the economy. A steep flattening of the yield curve is a sign that the Fed is in the later stages of tightening its monetary-policy belt. It's part of the broader process. But once it occurs, it does have its own implications for the economy and the markets.
Treasury yields should be viewed in concert with central-bank policy and changes in the availability of money and credit. The Fed influences supply and demand for money when it raises the fed-funds rate, since it pushes up money-market yields. To boost the funds rate, the Fed has to cut down on total reserves -- money that banks are required to keep around for backing up deposits.
That reduces how much money can be supplied to people and businesses for borrowing and investing and it crunches the availability of credit that Americans now rely heavily on to keep up their spending habits. Banks' profits, meanwhile, are crimped because they can't make easy money by borrowing at low, shorter-term rates and lending at high, longer-term rates -- one version of the time-honored carry trade. Higher rates can grind the borrowing and lending process to a halt -- or it can reverse, where people pay their loans with money they normally would spend elsewhere. All told, economic growth is stunted.
The yield curve is flattening because Fed policy is working -- it's not a surprise that a higher fed-funds rate is followed by slowing growth in money supply and a narrowing in the spread between short- and long-term Treasury yields. This is clearly evident as 2005 draws to a close: Total reserves fell 4.1% in the past 12 months, and the contraction has happened at a faster pace in recent months because of the cumulative impact of 13 Fed rate increases. M2 money supply -- cash, deposits and short-term assets such money-market funds -- increased a paltry 3.4% in the last 12 months, the slowest growth in 10 years.
While the flattening yield curve is part of the process, it shouldn't be taken lightly. This barometer narrowed significantly prior to all of the recessions since 1954, as well as two major business slowdowns in 1967 and 1995. In the middle of those slowdowns, the economy grew at annual rates of 1.6% and 0.9%, respectively. Only quick and decisive Fed action prevented worse conditions. Since 1954, growth in M2 when adjusted for inflation slowed dramatically in the four quarters right before recession. The same thing happened with the slowdowns of 1966 and 1995. That is why both the yield curve and M2 supply are widely considered excellent leading indicators.
Growth of less than 1% in real M2 in the past four quarters, combined with a sharp contraction in total bank reserves, reinforces what the yield curve is telling us: The economy is headed for a slowdown. That means either less inflation, less real growth, or some combination of the two."
I hope that's not too wonky; it is as clear an explanation I've ever read, without dumbing it down too much. Note that the past 4 recessions were preceded by a Yield Curve Inversion, and prior flattenings have predicted a slowdown.
Here's a chart from today's WSJ:
click for larger graphic
chart courtesy of WSJ
UPDATE: December 31, 2005 5:13am
A reader asked for a study on inversions and recessions. Marketwatch reported that Merrill Lynch just released a study (on Friday!) on the subject:
"The historical record speaks for itself," said Merrill Lynch analysts in a report published Friday.
"In the past 30 years, the yield curve has inverted five out of the eight times the Fed has been tightening monetary policy. Each of those five times an economic recession has ensued one year later -- our fear (though not our base case) is that this time will be no different."
If anyone has access to this, please contact me about sending it.
Examining an Inversion
WSJ, December 23, 2005
Yields on Bonds Invert, Reflecting Unease About Economy's Future
THE WALL STREET JOURNAL, December 28, 2005; Page A1
Stocks could see rebound on data
Economic data and 4Q earnings to greet the New Year
MarketWatch, 5:01 AM ET Dec. 31, 2005
Inverted Yield Curve: Its different this time (not)
The yield curve, as measured by the ratio between the 10 and 2 year treasuries, is merely a few ticks away from inverting. This is something worth paying close attention to.
What's the significance of an Inversion?
It reflects a decreasing demand for capital (low long rates), and can also be read as the Bond Market's apprehension of a slowing economy -- why buy short Bonds if they are about to get even cheaper?
While not every inversion leads to a recession, every recession has been preceded by an inverted yield curve. Thus, it can be described as a necessary but not sufficient factor for a subsequent recession.
According to a Dow Jones article in today's WSJ:
"Bond analysts aren't holding out much hope that the 10-year Treasury note will end 2005 with a bang, but the yield curve may ignite some fireworks.
The benchmark 10-year yield, which is sitting just below the 4.4%-4.6% range it had been confined to for more than a month, probably won't stage a significant breakout during the last trading week of the year, analysts say.
But it's a different story for the two-year note. Amid upcoming supply as well as widespread belief that the U.S. Federal Reserve will raise rates one or two more times, the two-year yield is likely to head higher. A bond's yield rises as its price falls.
When the two-year note underperforms the 10-year issue, the difference between these notes' yields -- which slid to 0.01 percentage point last week -- has the potential to disappear altogether, and the two-year note's yield can even surpass the yield on the 10-year.
When shorter-dated yields overtake their longer-dated counterparts, the yield curve is described as inverted. It is a bond-market rarity that has historically foreshadowed recession."
The 2/10 relationship -- and whether it becomes inverted -- has been one of several traditional harbingers of ill economic winds. There has already been Inversion "in the shorter end of the yield curve, with two-year notes yielding about 0.04 percentage point more than five-year notes late last week."
Fed Chairman Alan Greenspan has noted that "its different this time." He has challenged the view that "inversion signals economic trouble, pointing out that the shape of the curve is less predictive than it once was."
Further, the depth and duration of the inversion also plays a hand in its predictive ability:
"While an inversion between two- and 10-year "seems in the cards," some bond managers expect the flip-flop in yields to be minimal -- just 0.1 to 0.15 percentage point over the next few months before things turn back around. A brief, shallow inversion won't signal any marked slowdown in the economy. Over the past several decades, the yield curve has had to invert by two percentage points or more before a recession materialized.
One bond portfolio manager noted that the market seems to be priced for the Fed to start easing rates as soon as it stops tightening them." (emphasis added).
Any good technician will tell you never to anticipate a breakout or technical signal. Thus, declaring a recession to be inevitable based on an imminent inversion -- or a non-recession based upon a short, mild inversion -- may not be the best market call.
Nonetheless, any inversion -- even a shallow and brief one -- would ratchet up an already elevated anxiety level in the bond market, as "investors worry about a cooler housing market, inflation and energy prices, particularly high home-heating bills" notes the Journal. And that's before getting to Mortgage Equity Extraction, Current Account Deficit, a shopped out consumer, an expensive ongoing War, and assorted ills left over from the equity bubble's collapse.
An inverted yield curve is not a guarantee of a recession, but it is nonetheless a worrisome thing. If it doesn't foretell a recession, its not because "its different this time;" rather, its more likely because only some conditions precedent will have been met . . .
UPDATE: December 27, 2005 5:13pm
That didn't take very long, did it?
Stocks tumbled Tuesday as the bond market gave signals that in the past have preceded economic slowdowns. The Dow Jones industrial average lost more than 100 points.
The yield curve, the spread between the yields of short-term and long-term bonds, inverted for the first time in five years. That means short-term interest rates were higher than long-term interest rates. Investors have been watching the yield curve closely because, in the past, inverted yield curves have preceded recessions.
The yield on the 10-year Treasury fell to 4.341 percent, while the two-year Treasury note closed at 4.347 percent.
Normally, lenders receive higher interest when they commit their money for a longer time. A surge in demand for short-term credit can flatten or invert the yield curve.
The last time the yield curve was inverted was 2000, Charles H. Blood Jr., senior financial markets analyst at Brown Brothers Harriman & Co. At the time, "it served its classic function of a warning," he said.
Investors have been watching for months as bonds' long-term yields and short-term yields grew closer. "Although an inverted yield curve does not always imply an economic recession, it has predicted a profit recession 100 percent of the time," Merrill Lynch's North American Economist David R. Rosenberg said earlier this month.
Dow Finishes Down 106 at 10,778, Nasdaq Finishes Down 23 at 2,227 As Yield Curve Inverts
Yield Curve May Become Inverted
Rate of the 2-Year Treasury Is Likely to Rise as 10-Year Flattens, Sparking Concern
DOW JONES NEWSWIRES, December 27, 2005
The “greatest irony” is that he is called the Maestro
PIMCO's Paul McCulley lays out a surprisingly stark
bitchslapping smackdown on Easy Al Greenspan. First, he quotes the Maestro:
"In perhaps what must be the greatest irony of economic policymaking, success at stabilization carries its own risks. Monetary policy–in fact, all economic policy–to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums."
This quote is actually one of a series of statements from the departing Fed Chair essentially claiming that we get Bubbles because Greenie did his job so damned well.
McCulley is having none of this; He deftly uses Al's own words against him:
"Ah, “the eventual exhaustion of the forces of boom!” Roll enough games without a fingertip ball and you don’t have to worry about overhooking it, as your arm ain’t got the strength. But you do have to worry about underhooking it into the gutter. For, if (1) the “greatest irony” of successful Fed-driven macroeconomic stabilization – notably achieving secular “price stability” – is excessive reduction of risk premiums, otherwise known as bubbles, and if (2) the only strategy available for addressing such bubbles is to wait for their “eventual exhaustion,” then (3) the “greatest irony” is not as Mr. Greenspan declares, but rather that he is called the Maestro."
As if that wasn't enough, McCulley notes that new Fed Chair Ben Bernanke does not see "the wisdom of relying exclusively on the hands-off-then-mop-up strategy" of Bubble management. Indeed, Helicopter Ben has already stated:
"When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly – that is, in a way that does not allow speculative misuse of the safety net – in the first place. Or failing that, to intervene and fix the problem when it is recognized.”
One suspects that McCulley -- Managing Director of the largest Bond Fund company in the world -- approves of Bernanke as Fed Chair . . .
Reflexive Disintermediation: Say What? Learning To Live With It (pdf)
PIMco, Fed Focus| November 2005
Ramifications of Eliminating the Mortgage Tax Deduction
What are the economic ramifications of the Mortgage deduction being eliminated? How likely is it that such a significant tax change is actually enacted?
Ever since the President's tax reform policy suggested capping the mortgage deduction at significantly lower levels, I've been wondering what the economic ramifications of this would be. Especially now, coming at the tail end of a huge Real Estate cycle.
The entire issue may be moot -- at least for now -- given the present political situation. Perhaps if President Bush were at full political strength, if he wasn't dealing with numerous crisis and scandals and staff indictments and the fading support for the war in Iraq, while still smarting from the rejection of social security reform, and if his own polling numbers were not at an all time low in popularity -- if all that were not weighing against him, the chance of eliminating or greatly modifying the home mortgage deduction might be 15-25%. Given his current predicament*, my expectations are that eliminating this extremely popular -- even beloved -- deduction are all but impossible. (Its surprising the opposition has not made more hay over this).
The home mortgage deduction is so ingrained into the economic fiber of the country, that the potential consequences of altering this are ginormous. The risk to overall economy, if this were to be even slightly mishandled, would be devastating. As is, the impact would be very significant, given Real Estate's contribution to the economy.
This is especially true, given the factors which have been driving the Real Estate boom.
Recall that back in May of this year, we referenced Northern Trust's Asha Banglore, whose research showed that from 2001 to April 2005, 43.0% of private sector jobs were housing related. In this week's Sunday Times, Daniel Gross further explored the correlation between Hosuing and Job creation (As the McMansions Go, So Goes Job Growth):
These data points are potentially worrisome, and not only for the legions of real estate brokers and Sheetrock layers toiling in offices and job sites across the country. In recent years, economists from Alan Greenspan on down have been discussing the way rising home prices and the growth of home-equity borrowing have fueled consumer spending, the piston that drives the country's economic engine. But in recent years, housing, real estate and the related industries have become a huge factor in another crucial economic area: employment growth.
After the brief and shallow recession of 2001, the resilient United States economy stubbornly failed to create payroll jobs at the rate of past recoveries. Economists and politicians blamed factors and trends like outsourcing, global trade, high benefit costs and productivity growth. But amid the gloom, the real estate sector shouldered the burden of job creation . . .
As a result of the boom, the economy is more concentrated on housing than ever before. "Residential investment as a share of gross domestic product is at the highest level in 50 years," said Jan Hatzius, senior economist at Goldman, Sachs."
When discussing these data points just 6 months ago, I found the pushback significant. There has been less reluctance to acknowledge this issue more recently. Its intriguing to see how these ideas have slowly come to be accepted by the mainstream.
An earlier NYT article looked at another aspect of the proposd Tax changes: How they fall on people, based upon various economic classes:
Possibly the greatest NYT graphic ever:
click for larger graphic
Was there a nefarious ulterior motive in the way this was executed? In an earlier piece by Dan Gross,
(Tax 'em Till They Turn Red) the elimination of the Mortgage deduction -- or more accurately, capping it at a much lower
level than the present ~$ million dollars -- is a way to offset tax revenue
losses from eliminated the Alternative Minimum Tax (AMT).
How much revenue? An expected $1.2 trillion over 10 years. And, as David Rosenbaum reported in an Oct. 19 New York Times article (which you now have to pay to read online), the panel came up with two simplification plans. Both would severely limit the size of the home mortgage deduction. Now the deduction applies to up to the first $1 million of a mortgage. The panel's plans would cut it down so that it would only apply to loans that are the "maximum that the Federal Housing Administration will insure." The sum varies by market, but the maximum is $312,895 and the national average is $244,000. Both plans would eliminate deductions for interest on home-equity loans or mortgages for vacation homes. And both would eliminate the deduction for state and local taxes paid, including property taxes.
Fascinatingly, Gross observes that the changes recommended by a commission appointed by the President will have much greater negative effects on taxpayers in Democratic regions. Its as if the tax changes are a form of economic gerrymandering whose impact will be to significantly reduce the net take-home pay of (surprise!) Democratic donors.
He proposes quite a fascinating thought experiment:
"Go to Realtor.com, punch in your ZIP code and a price point, then punch in another ZIP code in a different part of the country and the same price point, and check out the astonishing difference in what you get."
Doing so reveals that the so-called Blue states are high level of Government services, higher income, higher state and local taxes. Property values are significantly higher. The mortgage deduction in these regions is worth quite alot more than it might be in the lower tax/lower property value Red states.
Fascinating analysis . . .
As the McMansions Go, So Goes Job Growth
NYT, November 20, 2005
What's Behind the Boom
JAMES R. HAGERTY
THE WALL STREET JOURNAL, November 21, 2005; Page R4
Goodbye, My Sweet Deduction
EDUARDO PORTER and DAVID LEONHARDT
NYT, November 3, 2005
Tax 'em Till They Turn Red
The Bush tax panel's plan to screw Democrats.
Daniel Gross, moneybox
Slate, Posted Monday, Oct. 31, 2005, at 5:02 PM ET
* I am going to venture outside of my area of expertise and make a broad political observation: Typical Presidents get to make only 2 grand efforts during their terms: Oftentimes, one is a rhetorical jawboning ("Mr. Gorbachev, tear down this wall!") while the other is actual legislation. President Bush 's two efforts are the War in Iraq and Tax Cuts, and they will likely be his legacy. (the Medicare Prescription Drug Plan was a secondary program). Its hard to imagine that tax reform, social security privitization, or another military effort will gain any traction.
Housing Starts Soften; Builder's Bear Market?
The evidence is now readily visible, and its no big surprise to us: Housing Starts (seasonally adjusted) faded quite a bit in October -
WSJ: "The Commerce Department said housing starts decreased 5.6% to a seasonally adjusted 2.014 million annual rate -- the largest decline since a 17.7% drop in March. September starts, originally seen at 2.108 million, were revised upward to 2.134 million. Building permits, an indicator of future construction activity, fell 6.7% to a 2.071 million annual rate in the steepest drop since a 7.2% fall in September 1999.
Builders appear to be dialing back new construction amid growing inventories and signs of slowing demand. The estimate of new houses for sale at the end of September climbed to 493,000, a supply of 4.9 months at the current sales pace, according to an earlier report from the Commerce Department. The stockpile had gone up 3.1% from August and was 20% higher than a year ago. Meanwhile, new-home sales in September were 0.1% below last year's level."
There's not a whole lot to argue with there. But the more interesting question was raised by Justin Lahart today: Are the home builders in a bear market?
"Going by the rule of thumb that says stocks are in a bear market when they have fallen 20% below their peak level, home-building stocks are in a bear market.
Since hitting its peak in July, the Dow Jones U.S. Home Construction Index has fallen 21%. Some components have fared much worse."
That's an interesting take. Let me confess here that I have not owned any Home Builders this run. I have missed the huge ruun, on the basis of my macro risk/reward analysis (No one ever said full disclosure was fun).
JL gets to the really damning testimony later in his column:
"It isn't the only bout of selling that home-building stocks have seen in recent years, but this downturn may have more significance. As the stocks pushed toward their peaks this summer, management teams, founders and other insiders were steadily selling shares -- often a sign that business is peaking."
The last housing related piece was a terrific article in the Personal Journal on the flattening (and possibly inverting) Yield Curve. The main takeaway was to note that as Long and Short Rates converge, there are good reasons to avoid bank and housing stock. Here's the money quote:
LONG AND SHORT
The flattening yield curve -- when the gap between short-term and long-term rates narrows -- is generally bad news for small investors. Here's why:
• It often signals an economic slowdown, which can lead to lower corporate profits and a stock-market decline.
• If the economy contracts, corporate bonds could also suffer, especially riskier high-yield issues.
• For conservative investors who prefer to keep their money in cash, though, rates are close to long-term bond yields.
Flattening Yield Curve
courtesy of WSJ
UPDATE: November 20, 2005 8:56am
Interesting chart showing the Homebuilders Index Returns for the past 5, 3 and 1 years:
Housing Starts Declined 5.6% In October; Permits Also Slid
WALL STREET JOURNAL ONLINE NEWS ROUNDUP
November 17, 2005 9:43 a.m.
AHEAD OF THE TAPE: Razing the Roof?
WSJ, November 17, 2005; Page C1
A Message in the Bond Market
As Long and Short Rates Converge, Advisers Push Cash but Shun Bank and Housing Stocks
By MARK WHITEHOUSE, ELEANOR LAISE and RUTH SIMON
THE WALL STREET JOURNAL, November 17, 2005; Page D1
Bonds Signal Challenges Ahead for Economy
THE WALL STREET JOURNAL, November 16, 2005; Page C1
Corp Bonds 1830-2005
My colleague Charles Nenner has been painstakingly analyzing data, some of which goes back hundreds of years. (I will make these available as additional data is complied and analyzed).
Here's the first slice of historical data: Almost 2 centuries of corporate bond yields. The impact of WWII is apparent, as is the subsequent inflation spike (1960/70s) and reversal (1980/90s).
Corp Bonds 1830-2005
Source: Charles Nenner, Cycle Forecaster
This looks like one giant mean reverting system . . .
Greenspan: Yield Curve 'No Longer Useful' Gauge Of Economy
Federal Reserve Chairman Alan Greenspan announced in Congressional Testimony today that the "yield curve was no longer a useful gauge of the economy."
Greenspan also downplayed the risk of big foreign holders of US Debt.
Economists React to Fed
Yesterday, the the Federal Reserve Open Market Committee surprsied nobody with their 12th consecutive 1/4 point increase. The WSJ noted that further "increases appears unlikely to cease anytime soon," and that the Fed "restated its long-running view that "policy accommodation can be removed at a pace that is likely to be measured." (See Parsing the FOMC Statement)
This must be conusing as all hell to the No Inflation crowd. After all, if its only the core, why raise rates? Especially after the Fed's policy on bubbles is that its easier to clean them up afterwards than to identify and unwind them in real time.
Bernanke, if confirmed, will face a decided tightrope act starting immediately. Will he earn his inflation-fighting stripes and continue down the path Greenspan started? Or will he bow to the concerns of the consumer and take a pause at his first official meeting? If the core inflation data remains as benign as it has been AND we get some mediocre holiday numbers, we think Bernanke would be wise to reevaluate the situation, and be leery of risking 'inverting the yield curve' in the 1Q of 2006.
-- John B. Norris, Morgan Asset Management
* * * * * * *
It seems clear that policymakers are not looking to send any new signals at this point. With the markets only recently having come around to pricing in a reasonable Fed path, the last thing the FOMC wants is to trigger a whipsaw in sentiment. No doubt, there was further discussion at this meeting regarding the appropriateness of providing forward looking guidance as the fed funds rate approaches the neutral zone. We suspect that the official statement will undergo significant change in the not too distant future, but the Fed is justifiably wary about implementing such a shift at this point due to a fear that it could be misinterpreted.
-- David Greenlaw, Morgan Stanley
* * * * * * *
This statement suggests that Greenspan's JEC testimony on Thursday is unlikely to contain any significant new message on monetary policy. We continue to look for quarter-point hikes at the December 13th and January 31st FOMC meetings and we expect that Bernanke will continue with further rate hikes in the Spring.
-- John Ryding, Conrad DeQuadros, Elena Volovelsky, of Bear Stearns
* * * * * * *
There is a small change in the language relating to inflation from Sep 20: The Fed remains concerned that the "cumulative rise in energy and other costs have the potential to add to inflation pressures." "Cumulative" is new, and presumably is intended to mean that the dip in energy prices over the past couple of months is not enough to assuage inflation fears.
-- Ian Shepherdson, High Frequency Economics
* * * * * * *
"The cumulative rise..." sounds like an acknowledgement that what we have experienced so far is not a one-off event and not something that can be ignored. I am guessing that this word was very carefully chosen to give the right tone to the message. It's as if they are saying that now is not the right time to let our guard down. It does, after all, take time for these changes to work through the economy. If pressure is building now, it may be a few months before it affects the headline CPI in a big way. The heating season is ahead. The rate hikes are not over.
-- William Polley, Western Illinois University
* * * * * * *
Recent indicators point to a rebound in manufacturing output from a temporary hurricane-induced setback in the month of September. Consumers -- who have been "shell-shocked" by higher gasoline prices and utility costs -- pulled in their horns on consumption in September and October. This sets the stage for a modest expenditure growth slowdown in the fourth quarter, providing support for the Federal Reserve's very gradual approach to adjusting rates.
-- Brian Bethune, Global Insight
* * * * * * *
The message from the FOMC continues to be that their central case scenario remains one where the tightening process will continue. Going forward, should Fed officials start to feel that the current pace of tightening needs to be altered, we would expect them to prepare markets for that event through public comments. Therefore, unless steered otherwise by Fed-speak, it seems sensible to expect further 25bp tightening moves at upcoming meetings.
-- Joshua Shapiro, MFR Inc.
November 1, 2005 3:47 p.m.
ex-Inflation, There is No Inflation
If that title has you confused, than you are probably not a fan of the CPI ex- food and energy, occasionally referred to as the core inflation rate. That’s the measure some Economists have been using to track the rate of inflation. It’s a foolish game played by those whose grasp on economic reality is tenuous at best.
Ostensibly, removing the more volatile elements of inflation data points avoids having a single outlying month disrupt data. Some of the more numerically literate of you might note that a simple moving average would do the exact same thing, yet allow any simultaneously rising prices to be revealed for what they are.
For whatever reason, some choose to ignore this approach. Instead, they select the “ex-” methodology of looking at inflation “ex-” inflation. This “ex-” method ignores too many inconvenient facts, i.e., that the CRB Index has been in a strong uptrend since October 2001. Yet despite 4 years of rising prices, the core rate has been remarkably stable. One wonders what the appeal is of such a misleading indicator.
Mind you, this is not the first time the Dismal set has
purposefully shifted inflation data downwards. As The Economist
reminds us “when oil prices surged in 1973-74, then Fed chairman, Arthur Burns
asked the Fed's economists to strip out energy from the consumer-price index
(CPI).” This was to get a “less distorted measure of inflation.” Unfortunately,
they couldn’t stop with just oil - food prices were stripped out too, followed
by used cars, children's toys, jewelry, housing and so on, until around half
the CPI basket was excluded because it was supposedly 'distorted' by exogenous
It is no surprise that those who have been overly reliant on the core rate have been unpleasantly shocked recently. The “ex-” group insisted the Fed would pause; after all, why raise rates, if there is no inflation (not once you back out all the inflationary data). Their distress at the most recent hike is directly proportional to their failure to understand the difference between smoothing a data series to reduce volatility, and simply removing inconvenient data that suggests something one does not like. If that reminds you of the recent shenanigans of the Conference Board with their LEIs, than good - you have been paying attention.
Those who live in a seasonally adjusted, hedonically altered, optimized world have to occasionally confront the unpleasant reality of a universe that doesn’t care for their artificial constructs. Ignoring energy - the inflationary data in the CPI - is less than pointless; It shifts the focus away from exactly where it should be: On the part of CPI that has been rapidly increasing in price.
We've been discussing quite a few inflation related issues lately.
Here's an overview:
• Inflation/Shminflation an excerpt from Barron's discussing the impact of oil and Fed tightening;
• The History of Inflation ex-inflation a fascinating look at the last time the "core rate of inflation" became the rage -- in the 1970s.
• CPI versus Core Inflation for nearly a year as prices rose dramtically, the so-called core rate was declining.
• No Confidence . . . one of the dangers of inmlfation is its impact on Consumer Confidence and spending.
• Deficits and Interest rates do large deficits cause inflation?
• Wages & Inflation: 20 years while wages have kept pace with the cost of goods and services over the past 20 years, Housing, Higher Education, and Medical Care are what are squeezing consumers. Over the past 20 years, energy doesn't even make the top 3.
• Anti-Bubble or Anti-Inflation? What is motivating the Fed?
• Core Prices versus Non Energy Earnings Why do those who report CPI ex-energy report SPX earnings with Energy? Isn't that a wee bit inconsistent?
• Fun with Hedonics or: "How I learned to stop worrying about CPI and love inflation." With a title like that, do you really need any more info?
• Juiced Data Where the inflation misunderstanding all began . . .
Barron's agrees with our assessment that, CPI not withstanding, there is actually some inflation out there. Add Oil and Fed tightening, a voila! That's a recipe for a slowdown:
"If we didn't know better, we'd suspect the good governors are actually recognizing, as they've given broad hints they are, that inflation is very much alive and kicking, whatever the absurd government price readings show . . ."
Conditioned by the fiction that the price of energy isn't all that important to the economy anymore and numbed to the effects of rising interest rates by the regularity, predictability and modest size of the increases, investors have grown to shrug off their impact. Yet, rationally, by itself, either would be enough to cause serious economic discomfort. Together, they are really bad news.
Merrill Lynch's David Rosenberg points out in a Friday dispatch that "we're witnessing an event that has happened barely more than 15% of the time in the past five decades: a year that sees the Fed tighten (liquidity pinch), oil prices rise (margin and personal-income squeeze) and the equity market head lower (wealth effect, discount mechanism) -- a triple play.
Such a triple play has occurred only eight times in the past 50 years, and on seven such occasions, gross-domestic-product growth either slowed or stopped dead in the water. The odds, then, of a slowdown in 2006 are 88%, which David says without fear of contradiction, is not "a track record worth betting against." The decline in growth in the wake of triple-play years has averaged 2½%.
"So," David comments, "if past is prescient, we could well be in store for 1%-ish-type growth next year." And, he adds, wryly, "Something tells us that equity valuation, credit spreads and the dollar are not presently priced for such an outcome." Whatever could make him think that?
The Merrill data is attached as a PDF
IT'S A BIT EARLY TO CELEBRATE COLUMBUS DAY.
UP AND DOWN WALL STREET
Barron's MONDAY, SEPTEMBER 26, 2005
Thought of the Day: U.S. Economy Out on a Triple Play
Merril Lynch Economic Commentary, 22 September 2005
David Rosenberg Merrill.pdf
CPI versus Core Inflation
This will be the last in our series on inflation for today (hopefully).
As we noted earlier, there is historical precedent for Central Bankers looking at CPI inflation with the inflation data backed out of it.
A picture is worth a 1000 words, and the chart nearby is no exception. It explains the risk to those who ignore energy prices or other price increases. Focusing on the core data (ex- inflation) ultimately will lead you to miss the primary move in price rises and broader inflation.
As the chart shows, in 2002, CPI bottomed at exactly 1%. It moved nearly continuously up for the next 12 months. During the entire time of this rise in inflation, the so-called core rate was actually declining. The core rate hit was still falling, and kissed 1% in mid-2003 -- some 18 months after the CPI did.
This shows you how while inflation was clearly on the upswing during that entire period, those people who focused on the core rate were recieving misleading signals about price pressures. Indeed, to them prices appeared to be going lower while they were actually going higher.
You couldn't ask for a more perfect example of Inflation ex-inflation.
It was only in 2004 that the core rate began to tick higher, moving to 2% and then above. By then, it was quite late. Over the same period, CPI rose to 3 plus %.
Here's the Ubiq-cerpt™ from Jesse's WSJ column:
"The Fed yesterday raised short-term rates a quarter point for the 11th time in a row, to 3.75%. Some economists had hoped and (incorrectly) predicted the Fed would pause to see how Katrina's effects played out. But when the Fed acted, it was clear that policy makers remain more concerned about inflation.
They still paid homage to its beloved "core" inflation measure, trilling that it has been "relatively low." The core measure excludes food and energy prices because they are prone to swings that are, typically, outsized and temporary. But the core is increasingly outmoded as energy prices have undergone a sustained and sharp rise. "I think the Fed has started to think of [energy prices] as more of a core development," says Lehman economist Ethan Harris.
It's about time. But the Fed isn't just combating inflation. Though it doesn't say so directly, it's also fighting the insatiable risk appetite that it spawned by the shock of easy money it used to get us out of the post-9/11 malaise."
Fed Faces a Post-Katrina Conundrum: Slowdown in Growth, Rise in Inflation
JESSE EISINGER, LONG & SHORT
September 21, 2005; Page C1
The History of Inflation ex-inflation
Erik points us to this fascinating history of the core rate of inflation (aka Inflation ex-inflation), via the Economist:
"Stephen Roach, the chief economist at Morgan Stanley, worked at the Fed in the 1970s under the then chairman, Arthur Burns. When oil prices surged in 1973-74, Burns asked the Fed's economists to strip out energy from the consumer-price index (CPI) to get a less distorted measure. When food prices then rose sharply, they stripped those out too—followed by used cars, children's toys, jewellery, housing and so on, until around half the CPI basket was excluded because it was supposedly 'distorted' by exogenous forces."
"As a result, the Fed failed to spot the breadth of emerging inflationary pressures throughout the economy. It looks unlikely to make the same mistake this time . . . Prices took off in the 1970s largely because of serious policy errors. Policymakers now understand that rising inflation harms growth, and independent central banks are more likely to stamp on inflation swiftly."
"The real worry with rising inflation expectations is less that they herald a surge in inflation than that they will limit the ability of the Fed or other central banks to cut interest rates if growth stumbles. It is commonly argued in America that if the housing bubble were to burst, and falling house prices threatened to choke consumer spending, the Fed would slash interest rates to prop up the economy, as it did after the stockmarket bubble popped in 2001-02. But then inflation was falling. Today, with inflation rising, the Fed would no longer have that option. If the economy hits trouble, investors and homebuyers should not expect to be bailed out again."
History may not repeat precisely, but it sure does rhyme . . .
A nasty whiff of inflation
Global monetary policy
The Economist, Sep 22nd 2005
Parsing the Fed
The Sept. 20 statement announced that the Fed was raising its key short-term interest rate by one-quarter point to 3.75%, its 11th straight increase, despite uncertainty about the economic impact of Hurricane Katrina. The storm hurt near-term economic growth, which normally would call for lower interest rates. But it also has elevated inflationary pressure, which normally would call for higher rates.
PARSING THE FED
Weathering the Storm
WSJ, September 20, 2005
Deficits and Interest rates
Go figure: Deficits matter:
" . . . [T]he nation's budget deficit is a cinch to go from merely staggering to positively stupendous. At the risk of being economically unchic, we own up to an anachronistic belief that deficits do matter. And that, further, their impact is destined to be felt with conceivably incalculable consequences by a financial system that's already dangerously stressed, as this one is, with huge shortfalls in our accounts at home and abroad and a savings rate that's hovering between zero and zip."
That quote was from Barron's Alan Abelson, who believes that not only do deficits matter (duh), but enormous deficits will make interests rates rise:
"Money to rebuild what Katrina destroyed will have to come from somewhere . . . which portends a huge surge of borrowing. That, in turn, means the supply of Treasuries will balloon, joining the heavy flow of bond sales from the portfolios of insurance companies rushing to raise cash to meet the torrent of claims in Katrina's wake. Which likely spells higher interest rates and all the bad things that may issue from them in an economy so lopsidedly dependent on a housing boom created and sustained by cheap money. A prospect, we might note, that has helped send gold, that indefatigable anticipator of woe, to its highest price since 1988."
Well, rates may be going up, but at least we know that ex-inflation, we have no inflation.
Hmmm, that gives me an idea: We should start reporting the budget deficit, ex-revenue shortfall. Then interest rates (Ex- any rise) will stay low!
Hey, this economic planning thing may be easier than you first thought . . .
Big Repair Job
UP AND DOWN WALL STREET
Barron's, MONDAY, SEPTEMBER 19, 2005
Its Gold Jerry, Gold!
There's an interesting debate today on Gold at Real Money. Some people actually think that Gold reflects future expectations for inflation (sarcasm strictly intentional).
For those keeping track, I mentioned the GLD holders on Power lunch on March 30, 2005, (CNBC).
All this deficit spending may lead to higher rates, more inflation, and private capital crowded out, if left unchecked.
Not too worry too much: Max Sawicky figures out how to pay for everything, from Katrina to Iraq to all other deficit spending.
One last thought: As we noted in the past (here and here), the lack of increased supply in the 30 year Bond has sent managers after the 10 year. That, in my opinion, is a reason for part of the cinundrum.
When the 30 Year returns in February -- we can expect to see that limited supply issue disappear -- and that means rates ticking higher.
Except for Inflation, there's no Inflation
So let me make sure I completely understand this: If we back out all of the inflationary data from the CPI, and PPI, there is, um, no inflation?
Thanks for clarifying that.
While the Dismal Set -- and the majority of CNBC guests -- continue to spout such foolish nonsense, its nice to see that at least the WSJ wasn't bamboozeled. Their online headline read: Consumer Prices Climb 0.5%
"Gasoline prices shot up 8.3%, the biggest increase since February 2003. Food prices, however, were unchanged for the first time in nine months. Medical-care prices were unchanged after nearly 30 years of increases. Housing prices grew more slowly in August, falling to a 0.2% rate from 0.4% in July. Automobile prices fell 0.5%, half the rate of decline recorded in July."
You can see more from the dismal set below . . .
UPDATE I: September 16, 2005 10:54 am
Its the ultimate Hedonic adjustment: Chart of the Day shows us graphically that without the items that are going up in price, there is hardly any inflation at all!
UPDATE II: September 17, 2005 11:54 am
The first official chart from the weekend WSJ:
UPDATE III: September 24, 2005 2:54 pm
Here's a round up of all our recent discussions on inflation
Consumer Prices Climb 0.5%
Katrina Helps Propel Jobless Claims
To Highest Level in Nearly 10 Years
WALL STREET JOURNAL, September 15, 2005 5:44 p.m.
Consumer prices rose 0.5% in August, but excluding volatile food and energy costs, the core inflation rate held steady at 0.1%. Economists, who weren't surprised by the numbers, weighed in on the post-Katrina inflationary effects of energy prices and what the trends might mean for the Federal Reserve's meeting on interest rates next week. Following are a handful of economists' reactions.
Please name the few Economists you think make some sense, based upon their quotes, in the comments section (below).
Core consumer inflation appears to have peaked after rising for most of the past 18 months.
-- Steven Wood, Insight Economics
* * *
[P]rospects for a reversal of recent energy-price increases and the absence of other fundamental inflationary pressures indicates inflation provides no significant justification for raising interest rates further at this time.
-- Peter Morici,University of Maryland
* * *
[W]hile core inflation could well inch up in the coming months, particularly as some of the recent surge in energy prices leaks through, it is unlikely to accelerate by enough to scare the Federal Reserve into a more aggressive tightening mode. We continue to think that a trend of [quarter percentage point] tightening moves are likely at upcoming Federal Open Market Committee meetings (although the aftermath of Hurricane Katrina could cause a temporary pause in the process).
-- Joshua Shapiro, MFR Inc.
* * *
[We] are still concerned about the potential for either energy price pass-through or higher inflation expectations becoming embedded in the economy as a result of high gasoline prices.
-- John Ryding, Bear Stearns
* * *
Since more than 90% of the prices in the August survey were collected before Hurricane Katrina struck, the September and October headline CPI numbers will likely be even higher. ... Given recent increases in airline ticket prices and the increasing ability of shippers and truckers to pass on higher fuel prices, we will likely see an acceleration of core inflation in the next few months. ... Currently Global Insight predicts that the Fed will take a breather in one or both of the next two meetings, before resuming its tightening cycle.
-- Nariman Behravesh, Global Insight
* * *
[T]he headline CPI could be up as much as 0.8% in September mainly because of surging prices at the gas pump. ... We expect to see only a slight uptick [in core inflation] in coming months partly reflecting a reversal of the [downside] quirk in hotel rates. ... [W]e look for the core CPI to reach +2.7% by the end of 2006 as some of the recent energy spike is gradually passed through to prices of other goods and services.
-- David Greenlaw, Ted Wieseman, Morgan Stanley
Wondering When Energy Costs Will 'Leak' Into Core Prices
September 15, 2005 11:04 a.m.
3 and 2 year yield curve inversion
One of our commenters today noted the 2 and 3 year yield curve inverted
Here's what that looks like, intraday:
click for larger chart
I can't say I know what this means . . . any idea?
Sunday Nite Linkfest
I've been travelling, working on two killer projects (one finance related, the other, a deadly research piece on the music industry) -- so the weekend link fests have suffered. While its still ugly out, I'll post a few items for your weekend. These are worth your while:
• Core Prices versus Non Energy Earnings - On the one hand, there's no inflation, ex-energy. On the other hand, SPX earnings look good -- but only if you include energy. Which is it?
• The California SUV Fill Up Index Here's what the 15 largest SUVs cost to tank up (brace yourself)
• While everyone is watching the (so-called) Real Estate Bubble, I don't see many people asking "Is Oil a bubble?"
• I've heard several commentators opine that maybe an inverted Yield Curve ain't so bad. They are wrong.
• When Oil prices and interest rates rise together, they have been a reliable Recession Predictor; Ask yourself if its different this time (and why).
• More on LEIs -- the Mis-Leading Economic Indicators
• If you think I'm skeptical about BLS/BEA stats, you should see this guy's work: Shadow Government Statistics
• Here's a fascinating idea: The Business Experiment -- Its is an open-source site meant to explore the wisdom of crowds, business, and the distributed nature of work. Can a group of online strangers democratically create a business plan, and wiki-like, execute it?
• Odd thought: Is Real Estate Climbing a Wall of Worry?
• Chris Anderson's Long Tail asks: “Why are the current generation of music services so dumb?” Compared to IMDB, that is . . .
• A very interesting blog: The Indian Economy
Understanding the Inverted Yield Curve
There's been a few comments intimating that, well, maybe an Inverted Yield Curve ain't so bad. I have to disagree in the strongest possible terms. And I have three decidely non-textbook reasons as to why: Cyclical, Liquidity, and Predictive factors.
Cyclical Factors: At the end of a recession, the Fed will have already been cutting short rates. The curve will be rather steep at that point in the business cycle -- and not coincidentally, its when and where an expansion is most likely to occur.
Conversely, when the curve inverts, its at the opposite end of the wheel -- when the economy has been heated up for a while, after an expansion, after a round of Fed tightening.
Liquidity: A steep yield curve is stimulative. Its because there's so little return for investors at low rates -- by cutting rates, the Fed essentially encourages any investment alternatives to bonds. Capital holders (investors) look to put their cash to work elsewhere; That capital investment tends to be broadly stimulative.
Predictive Bond Market: Regardless of what factors contribute to the yield curve inverting, it is essentially a collective expectation by the Bond Market that even LOWER RATES ARE IMMINENT -- in other words, lock in rates NOW while you can.
Why else would investors take a LOWER INTEREST RATE ON LONGER TERM LOANS THAN SHORTER TERM? You tie cash up for longer, there is lengthened risk, plus the opportunity costs -- the loss of the use of that capital for other potentially lucrative investments.
Why might rates get worse? Its the expectation by very smart money of a WORSENING ECONOMY and all that entails.
Its essentially an economic bet -- that this is the last chance to lock in mediocre rates before they get much worse. Someone else described (cant remember who) as "A chance to lock in rates before the bottom falls out."
If you would like to see specific examples of yield curves from varying years and how they played out there's an excellent primer at Smart Money that's well worth reading: The Living Yield Curve
There's an interesting dynamic swirling around the impact of Oil and the likelihood (or not) of a possible recession. Some economists are saying that, well, its different this time, and Oil won't precipitate a recession, that "Expenditures on energy are a sufficiently small share of GDP" that it won't matter much.
I disagree -- not because of the relative size of Oil to GDP, but rather, due to Psychology of consumers in light of inflation, very high Gas prices, weak job creation, Real Wages, and an ongoing messy War.
click for larger graphic:
graphic courtesy of NYT
Over the past decade, we've seen several developments that makes the average consumer more sensitive to fuel prices. Most of the country now drives larger vehicles: SUVs, trucks, large sedans. Fuel economy for the average suburban family is down significantly. Combine that with leasing rates that allow people to obtain much more expensive vehicles than they could otherwise afford to buy outright. That put alot of trucks on the road; Drive to any suburban mall or shopping area, and every other car is an SUV.
But it also allowed people to spend and indebt themselves into a position where they don't have a significant margin of budget safety. Now add to that the two recent wealth effects -- stocks in the 1990s, and homes in the 2000s -- that led people to feel flush, and further encouraged many of them to live relatively beyond their means.
Which brings us to 2005. While Oil may be a much smaller percentage of GDP today than it was in the 1970s, the relative financial conditions of indebted consumers may also be that much less able to absorb an extended shock than it was then.
There are two stats that always seem to get mustered to counter this: Some point to consumer debt, not as a percentage of GDP, but relative to net asset wealth. The other rationale is median personal income (not just wages) as showing how flush consumers are.
I find neither of these arguments convincing.
As we learned in 2,000, relying on net wealth which is subject to asset price fluctuation can lead to a rapid rise in asset to debt ratios when the values of those assets declines precipitously. When stocks crashed in 2000, suddenly people were sitting on a lot more debt percentage wise than before. Then the negative wealth effect led to a modest curtailment of spending, exasperating a mild recession.
Secondly, median personal income gains paint a misleading picture of the economy. A more accurate measure would be Real Hourly Wages. Thats the data point which impacts the vast majority of consumers, and therefore has the largest impact on spending. After inflation, we see little in the way of income gains. Median income, on the other hand, disproportionately reflects the benefits of tax cuts, dividends, and capital gains. These improvements are real, but not widely disbursed. Thats also why we see a bifurcated spending pattern developing: Wal-Mart's losses are Tiffany's gains.
Just because Bill Gates walks into a bar, everyone else in the bar isn't better off. Sure, the mean income just went up dramatically, but the median is hardly changed. That's an exaggeration of whats been occuring to personal income in the U.S. -- some are doing very well, while others are slipping backwards.
Back to the recession issue: Longtime readers know I am a fan of Chaos theory, periodicy and cycles (or at least the cyclical nature of business ). A possible recession in the 2006-07 time frame is hardly a stretch. Consider the past few contractions, and then fill in the blank: 1990, 1994, 2000, ______.
Its even easier to presume a potential contraction when one looks at how stimulus driven this post-recession period has been, and the net results of what happens as that stimulus attenuates.
Which brings us back to Psychology. How much additional pressure can the consumer absorb before pulling in his/her spending? Despite good economic headlines, consumer confidence is mixed, and the President's approval ratings have reached the nadir of his term (both Reagan and Clinton scored higher at the same time).
Consider all of the following: Record high gasoline prices, that fall back a little but stay inflated; Add a housing boom that doesn't crash, but merely fizzles. The ongoing refinacing machine which drove so much consumer spending decellerates rapidly. Add to it a War which the majority of the country now believes turns out to be "Not worth it" and a significant percent (though not quite a majority) beleives we were led into under "false premises." Lastly, the myriad stimulus from the government -- tax cuts, ultra low interest rates, deficit spending, increased money supply, military expenditures -- all begin to fade.
What might all this a recipe for?
Economy Shows Signs of Strain From Oil Prices
By JAD MOUAWAD and DAVID LEONHARDT
Published: August 17, 2005
Do Higher Oil Prices Lead to Recessions? (Yes)
Sunday, June 06, 2004
U.S. Gasoline and Diesel Fuel Prices, 08/15/05
AAA Fuel Gauge Retail Gasoline Prices
Oil Spike Won't Cause Oil Shocks of Past
By THE ASSOCIATED PRESS
Published: August 17, 2005
Interesting WSJ discussion on the flattening yield curve:
"Economists' explanations for what is happening to yields vary, many amounting to too much money chasing too few long-term investments, pushing prices up and potential returns down. Asian central banks and private investors, for example, have been big buyers of U.S. bonds. And as the U.S. population ages and the government prods companies to better fund their pension plans, demand has grown for the kind of long-term bonds that can guarantee payments to future retirees.
The Fed's own actions also have played a leading role in keeping long-term interest rates low. Over the past year, the Fed has been unusually open about signaling its intentions to the market before each of its short-term rate increases. The predictability of Fed policy has calmed peoples' worries that a sudden increase in inflation could erode the value of their investments, making investors more willing to part with their money longer, for little extra return.
You know the real reason I'm a referncing this is because I am some bizarre combination of a graphic groupie and a chart whore. Well, we aim to please:
click for larger graphic
What's this mean to investors? In a word, RISK:
"It has also encouraged investors to take on more risk -- for example, by buying long-term bonds with money borrowed at short-term rates. In one indication of investors' rising tolerance for risk, securities dealers' outstanding short-term loans to their clients reached an all-time high of $3.5 trillion at the end of June, though it has decreased somewhat since.
If strong economic data -- or some shock such as a sudden rise in inflation -- prompt investors to sell bonds purchased on borrowed funds, long-term interest rates could jump. For now, though, added demand for long-term bonds is pushing prices up and interest rates down, undermining the Fed's ability to influence long-term rates."
Go figure. Ultra-low rates encourages speculation in the fixed income markets.
When all is said and done about Greenspan's Chairmanship, I believe his final legacy will be his surprising willingness to encourage specualtion -- in Nasdaq stocks, in Real Estate anmd now in Bonds.
Fed's Fight Squeezes Banks, Spooks Markets
Vanishing Gap Between Rates For Long- and Short-Term Debt Means Lower Profits for Lenders
MARK WHITEHOUSE and ROBIN SIDEL
WALL STREET JOURNAL, August 9, 2005; Page C1
Real Federal Funds Rate: Hikes with Teeth
One of the differences between the prior 9 hikes and yesterday's (as well as future hikes) has been the Real Federal Funds Rate. Its now above zero. Meaning, the Fed Rate of 3.5% is above inflation.
Prior rate hikes were actually still stimulative, with each hike leaving the Fed Funds rate "accomodative" -- only 25 basis points less so than before.
It was like a big bowl of candy was sitting on the Fed cocktail table, and each FOMC meeting, they removed a few pieces.
The Candy was still there, but a there was a little less each time.
Now, however, we are no longer in accomodative territory. Each hike no longer means a bit less pleasure -- now, the Fed has taken out the paddle and with every hike, they are swatting all of us on our collective arses.
We have transitioned from a Fed giving us a little less pleasure each hike, to a little more pain.
I expect the repurcussions for this will be significant.
This was mentioned last week in a WSJ ccolumn titled "No Stairway"
"Three steps and a stumble" is the old Wall Street saying on what happens to stocks when the Federal Reserve raises interest rates. But even though the Fed has been stepping up the overnight target rate it charges banks for more than a year, the stock market's footing seems sound. . .
An additional factor behind stocks' Teflon-like reaction to the Fed, says John Bollinger of Bollinger Capital Management, is that the funds rate only recently rose above the rate of inflation as measured by the consumer-price index. In June, the real federal-funds rate -- the funds rate minus the rate of inflation -- came to 0.5%. That is a little below where it was in 1994, right before the Fed started increasing rates.
A negative real funds rate creates a strong incentive to borrow money to buy goods and services, since those things will cost more in the future than it will cost to repay a lender. It brings lots of cash sloshing into the economy -- cash that can be used for buying not just goods, but houses, Treasurys and, of course, stocks.
Mr. Bollinger thinks that now that the Fed has brought the real funds rate into positive territory, investors should become a bit more cautious. But after seeing so many rate increases come and go with no effect, that might be a tall order.
Hey Justin -- is the title a Wayne's World reference?
AHEAD OF THE TAPE
By JUSTIN LAHART
August 4, 2005; Page C1
Fed Follow Up
"They, the Fed watchers, will carefully examine the memo, checking its wording, its spelling, its punctuation, and the rag content of the paper it is printed on.
My personal position is 3.5%, exactly the same words, 2 spelling errors, a comma changed to a semi-colon in the second to last line (Is this significant?), and 25% rag content. I am neutral on the ink color.
Last time the Fed watchers got pretty excited about what looked like a change in wording, but it turned out to be drool from one of the older members who fell asleep while signing the memo. False alarm.
The FOMC members, of course, have been watching out the windows all day, wondering how the Fed watchers will interpret their words. The psychology so thick you can cut it with a chain saw.
Nothing more needs to be said . . .
Put down your Dictionaries and Back Away Slowly
Dr. John Rutledge
August 09, 2005
Real Estate Begins to Cool
Two major themes we have been discussing for quite some time appear to be coming together:
Those themes lead us to following: 5 key factors suggest to us that Real Estate has finally begun to cool:
2. Prices paid
3. time on the market
4. relative strength of Condo sales
5. Mortgage rates
Given Real Estate’s contribution to economic growth, this is quite significant. Despite recent data to the contrary, the Real Estate complex has been the most robust economic growth engine in the US. We credit half-century low interest rates, demographic trends, disenchantment with equities, and the decreasing availability of buildable plots of land for this phenomenon.
We spoke with Real Estate Agents in the NY area, and they have all noted a pronounced shift. Bidding for Houses is far less furious than it was a few months ago. Sellers who were inflexible on price wait much longer to sell, as Buyers have become more selective. Even the credit worthiness of some bidders is not as strong as it was prior. Anecdotal evidence, combined with quantitative data, suggest that we are now in the latter stages of the housing boom.
As the sector begins to further cool, we foresee several significant elements coming into play: 1) Housing related employment slows and reverses. Think real estate agents, mortgage brokers, durable goods manufacturers, home-builders and retailers. They could move from a hiring mode to laying off sometime over the next 18 months; 2) Major retailers (Home Depot, Lowes, Sears, Bed Bath & Beyond) will feel the pinch, as revenue and profits begin to slow; 3) Home builders, still cheap on a P/E basis, will begin to throttle back growth.
How the builders handle the slowdown will be a function of their prior positioning. Those with little debt, prime locations and a strong back order will likely see only a modest slowdown. However, Jeff Matthews notes that some homebuilders are engaging in speculation; He specific cites Toll Brothers as “playing the spot market.”
The silver lining is that slowing Real Estate gives the Fed the excuse it needs to stop tightening, assuming their motivation was to let some air before a real bubble got too far out of hand.
Given the significance of this sector and the relative modest strength of the rest of the economy, we suspect the Fed will fail in their attempt to engineer a soft landing.
We expect a recession in the 2006-07 time frame.
UPDATE August 10, 2005 6:47am
The NAR noted on Tuesday that they too expect Real Estate to cool off into 2006:
A runaway real estate market this year has many economists – and even Fed Chairman Alan Greenspan – fretting about the housing bubble. But the people who sell real estate for a living predict a soft landing for the red-hot market, not a crash that could wipe out homeowners' gains of the last three years.
The Federal Reserve raised short-term interest rates for the 10th consecutive time today, lifting its short-term rate target to 3.5% from 3.25% and signaling that more increases are to come. The Fed ist rying to deal with strengthening economic growth, a slightly less favorable inflation picture and still-low long-term interest rates.
“The housing market is probably close to a peak right now in terms of sales activity, but there is tremendous momentum," said David Lereah, chief economist for the National Association of Realtors. "Sales are expected to coast at historically high levels into next year, but they will trend slightly downward.
Realtors See Market Coasting For The Rest Of The Year
August 9, 2005
Is the Bond Market Hampering the Fed?
Here's a real conundrum for ya: Who do you fight, the Tape or the Fed?
That's my takeaway from an interesting WSJ discussion earlier this week: "As the Federal Reserve prepares to raise short-term interest rates again next week, officials there increasingly believe the bond market, which sets long-term rates, is diluting their efforts to tighten credit and contain inflation.
The result: The longer the bond market keeps long-term rates unusually low, the further the Fed is likely to raise the short-term rates it controls in an effort to keep the economy from overheating. Conversely, sharply higher bond yields would encourage the Fed to stop raising short-term rates."
Graphic courtesy of WSJ
I do not believe bonds to be overvalued, as the Chairman implied in a recent speech. Low yields are consistent with my expectations for modest economic growth next year --especially if the Fed keeps tightening.
Ultimately, I think the Bond market is more powerful than the Fed, at least over the long run. Thus, you watch the Fed (closely), but you don't fight the tape.
Fed Sees Bond Market Hampering Its Steps to Keep Inflation in Check
The Wall Street Journal, August 3, 2005; Page A2
The Return of the 30 Year Bond
Let’s not mince words: Canceling the 30 year bonds, when rates were low and heading lower – towards half century lows – will go down in history as one of the most imprudent and irrational bungles ever made by any government anywhere. That’s saying something.
It also points out the foibles of a problem us Humana Beans (and bean counters) have: Our tendency to over-emphasize recent data, at the expense of longer trends. We’ve discussed this in the past.
Despite an historical Federal deficit (a half century worth and rising), the surplus of cash following an enormous tech bubble was hardly an intelligent basis for canceling our primary and least expensive deficit funding mechanism, and we said as much at the time. To draw the conclusion that the U.S.’ budget deficit was not structural but cyclical requires a kind of optimism that is hard to reconcile with real life experience. Call it the triumph of the economic idealogues over reality. This is not revisionism, but something we discussed way back when.
Anyone can be wrong. What is unacceptable, as a famous hedge fund manager once said, was staying wrong. When interest rates hit 40-year lows 2 years ago, its all but unthinkable that Treasury didn’t bring back the 30 year.
Up until now, everyone in America got to refinance their debt at ultra low rates – except Uncle Sam. As taxpayers, we now can join homeowners, consumers and business in starting to clean up, however belatedly, our national balance sheets.
Note that’s not the same as reducing our debt – all we are doing, in very small $30 billion steps, is lowering our interest servicing. Still, saving a few percent on $30B ain’t chicken feed. To paraphrase Senator Everett Dirksen, save a few percent in interest payments on $30 billion here and $30 billion there, and soon you're talking about real money . . .
UPDATE: August 4, 2005 10:01 am
A quickie: I've been reading all your comments, and I promise to address them (been on the go for the past 48 hours, moving offices and otherwise running around, and it won't get better til Monday).
The one thing I have to laugh about is the accusation of conspiracy theories; As I wrote just last month:
"While conspiracy theories may be sexy, the reality is far more mundane. Its all there if you have the temerity to dig thru endless data (eternal vigilence and all that). This must be terribly disapppointing to the black helicopter/tinfoil hat crowd.
The amazing thing is that most people don't bother. By "most people," I am referring to the economists, journalists, strategists and fund managers who trade off of this data."
Lastly, what's an update without a chart:
click for larger graphic
Graphic courtesy of NYT
Graphic courtesy of NYT
Fed and Markets
I rarely find anything to disagree about with Gary B. Smith (Chartman for Bulls & Bears, and columnist on RealMoney) -- so when I do, I find it noteworthy. His comments yesterday on the Fed and Markets were exactly one of those incidents:
"OK, here's a trivia question: Over the past 10 years, when has the Federal Reserve raising rates caused the market to decline?
The answer? Never.
I've shown the chart below on a few occasions, but with Fed Talk likely to heat up soon, it's worth looking at again.
The chart maps out what the market has done over the past decade or so along with what the Fed was doing with the fed funds rate. As you can see, they've pretty much followed one another up and down."
click for larger chart
chart courtesy of Real Money
What the Chartman is overlooking is that the Fed's impact on markets is not typically coincidental -- meaning, the result of their actions does not show up as an instantaneous correlation. Instead, the causative relationship between what the Fed does and the market's subsequent reaction typically includes a 6 to 9 months lag. Just look at he chart GBS used:
In late 1995 / early '96 -- the Fed cut -- markets were higher 6 months later;
From late '99 to early '00 -- the Fed raised -- markets were lower 6 months later;
From late '02 to early '03 -- the Fed cut -- markets were higher 6 months later;
I would explain the delay between the Fed event (cut or hike) and the reaction simply: the subsequent impact on the economy takes about a year, and therefore corporate profits take that at least that long to improve or decay (at least those attributable to Fed action). Hence, even a 6 month lag in stock prices is anticpating the impact of Fed action further down the road. The entire process takes a while to work their way through the system.
So where are we today?
From late '04 to '05 -- the Fed tightened; Let's see where markets are 6 months later.
ADP's Gains Need to Be Processed
Gary B. Smith
RealMoney.com, 7/26/2005 8:35 AM EDT
Vulnerable Mortgages and the Depegging of the Chinese Yuan-
"May you live in interesting times . . . "
Yesterday's announcement of the de-pegging of the Yuan to the US dollar had an immediate impact: Bonds across the yield curve all rose about 10 basis points. As we noted yesterday morning:
"the Real Estate Complex has been the most robust segment of the U.S. economy. If the Chinese can succeed (where the Fed failed) in raising U.S. long rates, the strongest part of the US economy is at risk. While we know real estate had to slow eventually, the question is how fast will it occur, and how dramatically."
That's my key takeaway from this entire issue. Why? Because I doubt it will impact exports much -- given that the massive wage disparities and cost structure differentials are so significant, a 2% (or even a 12%) currency change won't amount to a whole lot, relative to imports.
The position I've staked out (vis-a-vis Real Estate and the Economy) is decidely in the minority. To reiterate:
1) Real Estate is a very different type of asset than stocks;
2) Housing is not a bubble -- rather, it is an extended asset class -- and therefore is vulnerable to a 25-35% retracement, as opposed to a Nasdaq like 80% crash;
3) The rest of the economy is mediocre; Back out Housing Related activity, and there's not a whole lot of there there.
We've been beating that drum for many months now. Finally, the meme that Real Estate has been driving the economy has only recently received widespread attention.
So the currency shift, and its resultant impact on long rates (and therefore Real Estate), plays very much into our Bearish 2006 scenario.
Consider the Yuan depegging in light of the increasing number of "exotic" mortgages: 30-Year Fixed mortgages are down to just over 40% from ~70% of all mortgages; Adjustable mortgages, up from under 10% to over 40%; Interest only mortgages, up to 20% -- from 0 in 2001.
Its hardly intelligent to take an APR when rates are at half century lows; Interest only mortgage holders don't really own their homes -- they are more like renters with an option to buy. Hey, that's the free market -- people are free to be as dumb a they want to be.
Where it becomes a macro-concern is that all these loans get sold, securitized and packaged, courtesy of
Sallie Fannie Mae and Freddie Mac. If we see a big wave of defaults, that could have deep and far reaching ramifications on the country's capital markets.
Have a look at a recent WSJ discussion of related topics:
WSJ: ". . . offering alluring and controversial mortgages that require unusually slim payments for a few years, before bigger sums fall due. Some customers use these loans to borrow as much as seven times their annual income -- a staggering jump from the two-times-annual-income level that was the rule of thumb when the 30-year fixed-rate mortgage was the norm.
As real-estate mania intensifies, the mortgage industry keeps making it easier to borrow. "Low documentation" loans are catching on, including ones where lenders simply take borrowers' word about their income and don't ask for pay stubs. Repayment terms sometimes are stretched as long as 40 years, to help shrink monthly payments. In the most common twist, lenders aren't requiring even token efforts to repay principal in the early years of a mortgage. Interest-only payments suffice. In some cases, borrowers can even pay less than that, allowing interest to pile up and be repaid later.
Skeptics worry that this easy-credit euphoria could end with a real-estate crash and waves of problem loans. Federal Reserve Board Chairman Alan Greenspan warned in June that housing prices in some areas appeared "unsustainable," adding that he was concerned about "the dramatic increase in the prevalence of interest-only loans." In a recent Wall Street Journal survey of 56 leading economists, 11 named a possible housing bust as their biggest worry for the economy."
Equally disturbing: Most of Wall Street and Washington D.C. have applauded this. So far, I've found only myself -- and John Rutledge -- are overly concerned with the negative impact of this development. At least it will be fascinating to watch how this unfolds over the next 18 months.
Its ironic: "May you live in interesting times" is considered a curse -- by the Chinese.
Easy Money: A Mortgage Salesman's Pitch
Mr. Ray Touts Low Payments For the First Five Years;
Interest Keeps Piling Up A Chance to Buy That Escalade
THE WALL STREET JOURNAL, July 20, 2005; Page A1
Washington, Wall Street React To Chinese Yuan Revaluation
July 21, 2005 1:26 p.m.
Federal Reserve Responsibilities Outsourced to China
The Fed Chairman was overheard to remark: “If we can’t do it, maybe they can”
The Peoples Bank of China (PBOC) announced to day that they are effectively taking over the interest rate responsibilities from the US Federal Reserve.
The Chinese Central Bankers announced that, effective immediately, they are beginning a series of incremental rate hikes in the United States. The first rate hike was for 10 basis points on the 30 year.
The Fed’s inability to significantly impact long rates anymore is what led to the outsourcing.
Unlike the United States Federal Reserve, who hold interest rate meetings monthly, the Chinese Bankers will now meet daily. Look for rate announcements each day at noon.
Trillion Dollar Baby
All tongue-in-cheek analysis aside, today's actions are the net result of the United States consuming far more goods or services than it produces. Because of that, the Chinese have accumulated nearly a trillion dollars of US Treasuries. That makes them a de facto player in setting our interest rate policy and impacting our economy.
The brunt of the de-pegging on the U.S. economy will not likely be felt for some time to come. But war-gaming the various scenarios of this new development, we can see that many dangers are apparent. If we play out this scenario to its logical conclusion, we are led to some unsettling possibilities:
1) As we have been writing for quite some time now, the Real Estate Complex has been the most robust segment of the U.S. economy. If the Chinese can succeed (where the Fed failed) in raising U.S. long rates, the strongest part of the US economy is at risk. While we know real estate had to slow eventually, the question is how fast will it occur, and how dramatically.
2) US Consumers have grown reliant on ultra low interest rates and ultra cheap Chinese goods. The de-pegging will cause incremental increases in costs, while raising rates. This will negatively impact Wal-Mart, the largest importer of Chinese manufactured products, as well as other Chinese goods resellers.
3) Some theorists have worried about US reaction in the event of a Chinese attack on Taiwan. In an unlikely – but possible – scenario, the Chinese can, at will, and without ever firing a shot, inflict as much economic damage on the U.S. as if we were at war. Armed conflict becomes unnecessary when countries can net impact their competitors as if they were at war.
4) The United States Dollar is the default currency of the world. That gives an unprecedented amount of flexibility to US policy makers. Is the de-pegging the beginning of the end for this global currency structure? It’s too soon to tell. But we wonder how this might play out elsewhere.
What now becomes significant is the basket of currencies to which the yuan will become ever more pegged. A likely composition will reflect a basket of currencies in proportion to China’s external trade.
According to the Bank of NY, there are 10 currencies that make up almost 90% of China’s overseas trade: the U.S., Japan, Hong Kong, EU, Indonesia, Malaysia, Singapore, South Korea, Thailand and Taiwan.
China’s top ten trade partners (in Dollars):
The European Union (18.5%)
United States (17.5%)
Hong Kong (11%)
ASEAN nations (11%)
South Korea (9.5%)
Source: Bank of NY
It makes some intuitive sense for the PBOC to replace their US Treasury holdings with an equivalent amount of Sovereign Treasuries of the currency basket (Hey, that’s what I would do).
The ultimate impact of today’s events will depend upon how quickly and how much the PBOC decide to sell off some of their US Treasuries. Unlike the Fed, the Chinese Central Bankers do not believe in much in the way of transparency. Their plans have been somewhat uncertain.
What is not uncertain, however, is that our Current Account Deficit has granted a degree of control and authority to another sovereign nation over our own economy. The net results of that may be determined over the coming decade . . .
Macro Movers for 2H 2005
The Street.com asked for a "Macro Preview" for the second half of the year, and I obliged them with What to Watch: Macro Movers.
Its a "Big Picture" look at the second half of 2005, and what might be in store for investors froma macro-economic perspective.
I stake out the rather unremarkable position that, barring some unforeseen crisis, the same issues that have been driving the economy (as well as the financial markets) in the first half of the year are likely to continue doing so in second half of the year.
The big four are:
• Energy and Oil
• Interest Rates
I also look at 5 other problems percolating below the surface. Any of these have the ability to disrupt at some unknown time in the future -- whether its the 2nd half or sometime later I haven't a clue. These are all longer term issues with potentially serious consequences:
-Return of the long bond
-The U.S. dollar
No excerpt -- the entire thing is available for free.
Podcast: 2 minute overview on the column:
Macro movers in 2h '05.mp3
What to Watch: Macro Movers
RealMoney.com, 7/6/2005 9:48 AM EDT
Top Seven Reasons for Lower Mortgage Rates
John Herrmann is the Economist for Cantor Fitzgerald (and a nice guy to boot).
Despite his congenitally bullish outlook, I find many of his pieces to be thoughtful and thought provoking. Here are his reasons for significantly lower future mortgage rates:
We continue to expect that mortgage rates are headed towards 4.0% over the next three and a half years, and not towards 7.0% over the next three and a half years - the current rate for 30-Year fixed conventional mortgage rate is 5.47%.
Top seven reasons for lower mortgage rates
Increased competitive pressures amongst the nation's lenders;
Surplus capacity in mortgage lending services sector;
Financial innovation in the form of new mortgage products;
Improved pricing efficiencies in pricing these new, and existing, mortgage contracts;
Improved marking-to-market pricing of duration risk of mortgage contracts, towards the 5-year sector of the Treasury Note/Swaps curve, and away from the 10-Year sector of those curves;
Moderating core consumer inflation pressures in 2006 and beyond;
The back-up in the 10-year Treasury Note yield is likely capped below 4.5% over the next three years, and that yield could fall to as low as 3.0% during the next recession (in 4.0 years).
Thus, with this "constructive" outlook for mortgage rates going forward, and given our forecast for an additional 4.25 million net new jobs to be created over the next 3.5-years, we continue to expect that home sales will remain very resilient going forward, with a new record set in 2005 for total home sales (for the seventh consecutive year), and with a possible new record set in 2006 (for what could be the eighth consecutive year).
Again, when we strip out the growth in the US housing market, we estimate that real GDP is only growing at a 3.0% rate, and that non-farm payroll jobs growth is only +127.0K per month.
So, lower mortgage rates is one way that the US economy grows closer to its potential real GDP growth rate of +3.5%.
Verbatim Text Of Federal Reserve's Interest Rate Decision
The Fed speaketh:
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3-1/4 percent.
The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually. Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.
The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Edward M. Gramlich; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 4-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
I nominate this for the most understated phrase on the planet: In a related action, the Board of Governors unanimously approved a
25-basis-point increase in the discount rate to 4-1/4 percent.
Mortgage Rates versus Fed Fund Rates
I cannot find my notes on where this is from, but it looks like the WSJ:
DESPITE THE FEDERAL RESERVE'S rate raising campaign started June 30, 2004, fixed mortgage rates are lower now than they were a year ago.
The average rate on a 30-year fixed mortgage is 5.66%, down from 6.30% a year ago, according to Bankrate.com's national weekly survey of large lenders. As for one-year adjustable-rate mortgages, the rate is 4.69%, up slightly from 4.43% in June 2004.
While fixed mortgage rates don't move in lock-step with Fed actions, they do tend to be responsive to rate decisions. So the decline in mortgage rates has surprised some economists. At the beginning of the year, economic forecasts from several associations called for fixed mortgage rates to end 2005 near 6.5%. Now, some economists are revising their estimates downward, to 6%.
What's different? One factor is that the core consumer price index, a key inflation indicator that some say has a direct effect on mortgage rates, increased rapidly during the second half of 2004, and economists expected the pace to continue.
But the CPI has plateaued in 2005, remaining at 2.2% through May. "It put inflation fears away and has allowed long term rates to remain low," says Lawrence Yun, economist for the National Association of Realtors. --Steven Sloan
Its Different This Time Redux
Deustche Bank joins the list of pundits who have opined that "Its different this time."
In their Daily Economic Note, the Banks Economic research department opines that investors should Not Read Too Much Into the Flat Yield Curve:
The yield curve has been a terrible predictor of GDP growth over the last 15 years. The
chart below shows a rolling correlation coefficient between the slope of the yield curve and the growth rate in real GDP.
To calculate this we measure the yield curve as the basis point difference between the yield on the 10-year Treasury note and the Fed funds rate. We compare the slope of the yield curve to the growth rate in real GDP over the following year.
In the 1970s and 1980s, the yield curve was a very good predictor of the economy, evidenced by a very high correlation coefficient between the two series when it was consistently around 80%. The correlation coefficient started to break down in the early 1990s and actually went negative in 2001. It has improved somewhat, but remains well below where it was.
I do not want to critique any single indicator, nor do I have any bones about the criticism coming out of Deutsche Bank.
Instead, I want to point out this once removed chart they have created of the Yield Curve, torturing it somewhat to produce the graph below:
Source: DB Global Markets Research
Their position that a flat yield curve is not a good predictor of GDP is a strawman; Note that this is not how investors (I cannot speak for economists) primarily use the curve. Whent he Curve gets inverted, that's when investors should sit up and take notice.
Its worth pointing out that the yield curve is actually more than one variable; its a combination of two factors: short interest rates, which reveal the Central Bank's economic expectations. And, its a function of long rates, which embodies the Bond Market's economic expectations.
What we have seen historically is that the Yield Curve, when it gets inverted, is a fairly reliable predictor of recessions. And we know what recessions do to the stock market.
So whether or not a flattening Yield Curve itself is a good predictor of GDP is rather irrelevant to me (and to other investors).
Instead, watch for the relatively rare and aberrational inversion that may take place in the future. If and when that happens, I have one word for you: Sell.
Gross: Fed May Cut Rates By Year-End
Dow Jones is reporting that PIMCO's Bill Gross sees the Fed pausing at 3.5% by August. He is looking US GDP Growth at 2%-3% in the next 6 months.
Even more interesting, Gross notes the Fed may cut rates by year-end.
Note that my expectations (see this column) are for cuts to begin sometime in 2006.
I see your expectations for two more hikes .. And as long as we are making predictions, I will raise you a new series of rate cuts (yes, cuts), beginning mid-2006.
Why? 'Cause the Fed will be do what the Fed always does -- careen from one "situation" of their own creation to another -- while the side effects each prescription begets create a whole new round of fevers and chills, and yet a new prescription is then rolled out to treat those ills. It is an endless cycle.
Now, it seems Bill Gross one ups me. I suspect he's wrong, that the Fed might be reluctant to reverse course so quickly.
I'll see if I can track the rest of his comments down.
UPDATE: June 21 2005, 11:55 am
11:53 (Dow Jones) Speaking in Chicago, PIMCO's Bill Gross says he expects the Fed to take the target funds rate to 3.5% by August, and then pause. Gross, who has been increasingly bullish on rates, took things a step further by predicting the Fed may actually start easing rates by the end of the year. Meanwhile, he sees U.S. GDP growth slowing to between 2%-3% in the next six months.
"I think they will have to stop (raising rates) shortly" to keep the U.S. economy going, Gross told reporters after speaking at Morningstar Inc.'s (MORN) investment conference, projecting the economy will grow 2% to 3% in the next six months. Gross is managing director of one of the world's largest bond funds, with $450 billion in fixed-income assets under management.
UPDATE: June 22 2005, 10:45 am
More details can be found here:
Bill Gross: Fed to end rate hikes soon
Believes the Fed will end hikes this summer, then send rates lower; cautions against hedge funds.
June 21, 2005: 2:45 PM EDT
WSJ: Debate on the Fed
Here comes the reveal of the "project" referred to earlier today:
Econoblog: What should the Fed do? What will the Fed do?
A debate on the Fed and its impact.
(No subscription required)
Mark Thoma of Economist's View was an encouraging cohost, and we discussed the following issue:
In two weeks, the Federal Reserve Board will hold its two-day June meeting and will be considering what could be the ninth increase to the central bank's target for the federal-funds rate -- the rate charged on overnight loans between banks and the key to the rates charged on a variety of consumer and business loans.
Led by Chairman Alan Greenspan, policy makers have raised the rate from 1% last June to the current 3%, in hopes that a slow and steady increase can prevent slowing productivity growth and increased business pricing power from spiraling into inflation.
What will the members of the board do when they get together in June and at the four remaining meetings this year, and what should they do? Bloggers Mark Thoma, of the University of Oregon, and Barry Ritholtz, of Maxim Group, consider the possibilities.
There's also a comment-like message board devoted to the subject -- which also does not require a subscription. Anyone who wants to comment on the Fed discussion can (and should). Save the hate mail, and post here!
Thanks Mark and Kate.It was lot of fun (but exhausting). While I can hardly be called an expert on the Fed, I am an interested observer. And, I got out of wearing a suit for the day.
Go check it out . . .
Where Will Rates Go From Here? Experts Consider the Fed's Path
WSJ, June 15, 2005
WSJ Message Board
The Convexity Grab
Heady stuff from across the pond: FT looks at the "convexity grab" earlier this week when the 10 year crossed (albeit briefly) below 4%. Since we recently looked at some of the similarities between our two economies (U.K. foreshadowing U.S. Economy), lets have a look at FT's view's on our uinterest rates.
Their working thesis is that this could be yet another factor pressuring rates lower:
"If yields on 10-year US Treasuries fall much further, American homeowners will become big players in the Treasury markets. Without buying a single US government bond, they could push Treasury prices up and yields lower still.
The reason: a phenomenon known in the mortgage market as a "convexity grab". When US homeowners refinance and repay their old mortgages - which they do in droves when interest rates fall low enough - owners of mortgage-backed securities suddenly find that their bonds, which are based on pools of mortgages, are repaid faster than expected.
To offset this, MBS investors are forced to buy long-dated assets such as 10-year Treasuries. That pushes Treasury prices higher and yields down further, encouraging more refinancing. "It becomes a vicious cycle," said Walter Schmidt, manager of mortgage strategies at FTN Financial.
The effect stems from the unusual structure of the US mortgage market. Homeowners usually borrow for 30 years at a fixed interest rate, set by reference to the yield on 10-year Treasuries. In markets such as the UK, cutting short a fixed-rate loan would cost the borrower money. But in the US, the typical mortgage allows homeowners to refinance at any time without penalty."
If that's the case, one would expect a vicious cycle any time rates dropped. But that hasn't been the experience recently.
In the summer of 2003, when mortgages dropped to 5.1 per cent, we snapped back pretty quickly. With the 10-year Treasury yields hovering around 3.9 % earlier this week, we saw a similar bounce in 30-year mortgage rates -- they never fell much below 5.5%
FT suggests that convexity "hedging" has limited further pressure on yields, as fixed income managers anticipate this phenomena and plan accordingly:
"Mortgage refinancing leaves owners of MBS instruments holding cash instead of long-dated bonds. The cash can only be invested at lower yields than the bonds were earning before.
For this reason MBS - unlike most bonds - typically lose value when interest rates fall, and vice versa. Bonds with this characteristic are said to have negative convexity.
Refinancing also disrupts the "duration" of an MBS investor's portfolio, a function of its yield and the time remaining until the investor expects to be repaid.
As interest rates fall and homeowners refinance their mortgages, duration shortens. Because most investors try to maintain the average duration of their portfolios, they are left scrambling to find safe assets with long duration, such as 10-year Treasuries or interest rate swaps with similar maturity."
There are clearly parallels between these two economies, one would imagine the dissimilarity in mortgage refinancing would lead to major behavioral differences. That's what makes the British conumer behavior, so similar to the U.S. (as discussed here), so intriguing.
Interesting stuff . . .
US mortgages could set off vicious cycle
By Richard Beales in New York
Published: June 6 2005 20:16 | Last updated: June 6 2005 20:16
Is ReFi activity slowing?
Prior to July 2003, mortgage refinancing activity seemed to track movements in interest rates fairly closely. Since then, however, homeowners have been less than responsive.
Have we hit the limits to growth in the refi market? If so, it may be another hint that the home-as-ATM phenomenon has come to an end.
The real question is whether homeowners are scaling back of their own accord -- or whether circumstances have forced them to.
All about the Yield Curve
Its a great primer about various types of Yield Curves: Normal, Steep, Inverted, Flat or Humped.
The Living Yield Curve
One Bond Strategy
Upside-Down Interest Rates
Bad news for the U.S. that is worse news for the world.
Slate, Friday, June 3, 2005, at 3:31 AM PT
The Curve Gets Even More Conundrum-ed
The Penobscot Princess (having bolted Bear Stearns, but still running in stealth mode) graces us once again with her elegant prose:
Pension Benefit Guaranty Corporation (PBGC) posted the latest on the sorry state of affairs, signaling that US pension funds were underfunded by the egregious amount of $354 billion at the end of ’04. Compare to ’03 when the shortfall stood at $279 bil. (I guess this is what happens when corporations seize upon the advantage of lax reporting rules, but that’s another day, another story. Still, just the thought of this big, gaping hole, should give you the Willies.)
Look: The number of pension plans that are more than $50 million short of promised benefit levels rose from 221 in 2000 to 1,108 in 2004. Those funds have an average of just 69 percent of promised benefits on hand. Nice, eh?
Anyhow, the better point to be made from this latest charmer is the front running-inducing nature of the report. Think the need by pension funds to buy duration, then. Now think of all the fast money understanding this in a flash and taking the opportunity to “get involved” in the parade.
It never ends, does it?
In other words, underfunded pensions have to buy long bonds. But hedge funds know this, and they "front run." That's even more buyers (on top of China and Japan) helping to drive rates lower . . .
UPDATE: June 9 2005 7:15am
The WSJ has also noticed the story -- but its not the PBGC's deficit that should have us worried; Its the half a trillion in obligations that should be scaring us . . .
Pension Agency's Gap Is Expected To Balloon to $71 Billion in Decade
THE WALL STREET JOURNAL, June 9, 2005; Page A4
"Its different this time."
Make no doubt about it -- thats precisely what Alan Greenspan said about the "puzzling decline" in long-term rates.
In the past, a decrease in yield on the 30 year was a signal of upcoming economic weakness. The Fed Chair argued that "they aren't as reliable a signal of such weakness as in the past."
You see, "its different this time."
But is it really? We looked at the 4 factors impacting rates, and some things have changed: Most prominently, the incredibly dumb decision to stop issuing 30 year bonds. But the rest of the forces we see impacting bonds: global labor arbitrage with Asia exporting wage deflation, as well as the Asian purchases of Treasuries -- are long standing factors.
So why believe that its "different this time?" The WSJ suggests:
Since June 2004, the Fed has raised its short-term rate target to 3% from 1% and has signaled plans to raise it further, while the 10-year Treasury bond yield has fallen to less than 4% from 4.7%. That sort of decline in long-term rates "is clearly without recent precedent," Mr. Greenspan said via satellite to the International Monetary Conference, a meeting of bankers from around the world, in Beijing.
You know what else is clearly without recent precedent? A Fed trying to manage their way through a post-bubble environment by hyper stimulating growth via ultra-low interest rates and increased money supply.
Why the Fed Chief has invoked 9/11 as the reason for putting the world awash in liquidity, he should consider the only thing different this time is him and the Federal Reserve.
The last comparable bubbles -- 1929 in the U.S. and Japan in 1989 -- didn't see the massive liquidity inflows this Fed geenrated -- nor the problems the "Free Lunch" ultimately creates.
I do not advocate a return to the Gold standard like Greenspan's Objectivism hero (Ayn Rand) favors -- but I have to admit that I see their point. This massive manipulation of the global economy by the U.S. Central Bank has the potential to be enormously disruptive.
Here's the accompanying graphic:
Interest Rate Spread: 10-Year Treasury Bond Less Fed Funds Rate (3-month Moving Average)
Greenspan Casts Doubt on Import of Falling Rates
THE WALL STREET JOURNAL, June 7, 2005; Page A2
Yield Curve Message - It's Different This Time?
Paul Kasriel, Asha Bangalore
Northern Trust, June 08, 2005
Chart of the Week: 10 Year Yield (Post-Crash) vs Japan
Even in this recovery with near zero Fed Funds, job growth was weak and wage growth never materialized.
What will the next recovery look like?
Post Bubble Yields: U.S. 10 Year(Post-2000) vs Japan (Post-1989)
click for huge chart
Charts courtesy of JDC
The stimulation for the next recovery might be even more limited, given the extremes in current leverage and rates. If we follow the Japanese model, stocks could go down for several years, bonds go up even further, as the dollar rallies, materials and energy stocks do poorly. In this scenario, Gold diverges from the dollar and rallies strongly.
Quote of the Day
The greatest booms unfold when capital concentrates in one sector. When that capital shifts, you also find the result of the greatest financial panics in history.
Hu's in charge here?
I've been meaning to post a few words about Floyd Norris' column from last week (Friday), titled "Who's in Charge of Determining U.S. Interest Rates? It May Be Beijing."
Norris warns that the drumbeat in Congress to decouple the Yuan may have a unfortunate repercussions for interest rates:
"The Bush administration calls on China to allow its currency to rise and Congress talks of punishment if China does not do so.
Be careful what you wish for.
As speeches of low-level Chinese bureaucrats are read with care for hints as to just when China will allow its currency to rise, perhaps it would be better for Americans to ponder the impact of China's current policies.
Some might wonder just why the American politicians are upset. The way things work now, China sells to the world most everything the world wants and then buys United States Treasury securities. That helps hold down interest rates and stimulates consumer spending.
You can understand why China might not like to keep doing that forever. Those Treasury securities do not pay much interest, and they are sure to decline in value, measured in Chinese yuan, when that currency rises. But the largest vendor financing program ever has stimulated both the Chinese and American economies.
In Washington, the theory is that China's keeping the yuan low increases America's trade deficit. But the benefits to United States exporters from a modest rise in the Chinese currency would most likely be small, while the effect of higher interest rates could be larger if China cut back on its purchases, particularly if other Asian central banks decided that they, too, wanted to sell dollars.
If that were to happen, the impact could be acute in the housing market. Investors in housing stocks have been nervous for some time, happy to see ever-higher profits but worried that the good times must end someday and fearful that they could be left holding the bag when that happens."
Sharp observations from Norris. The textile industry in the U.S. is not where future growth will come from. Killing the rest of the economy to save a dying industry hardly seems all that bright . . .
Incidentally, the title of this post comes from Robert J. Barbera, the chief economist of ITG/Hoenig. It refers to Hu Jintao, the Chinese president, who is said to be debating whether to uncouple the Chinese currency and/or stop accumulating U.S. Treasuries. (I liked that better than "Careful Yuan You Wish For.")
Who's in Charge of Determining U.S. Interest Rates? It May Be Beijing
NYTimes, May 13, 2005