Wednesday, August 30, 2006

Your eyes can deceive you, don't trust them

On my Bloomberg yesterday, I saw the following headlines.


And I thought, well, the market's going to hate that. Sounds like there is a decent chance of the Fed hiking again.

Then I read a little further, and there is a lot more talk about weaker economics, particularly in housing, than previous Fed communications. I look up and see the 10-year has rallied from down 1/4 point to up 1/8. Taking the minutes as a whole, it sure seems like the Fed has growing concern about slowing growth.

So while the "close call" quote grabbed headlines on both Bloomberg and the WSJ, the Fed sees cooling growth as helping to keep inflation in check. So bond market rallies.

Here is my bold opinion.

1) The FOMC is legitimately unsure as to whether they have done enough policy tightening to stem the rise in inflation. They paused in August because they think they have done enough, but are truly unsure.

2) They want to make it crystal clear to consumers, industry, and the financial markets that they have no fear about continuing to hike rates if necessary. In fact, my bet is that most Fed economists would like the world to believe they would create a recession rather than face accelerating inflation. They are careful not to say such a thing for fear of political fall out from people like Maryland's own Paul Sarbanes. But having read many text books and academic papers by people who are now (or were) at the Fed, I really think that's what they believe.

3) They aren't especially worried about a recession, but know that their own manipulation of interest rates is wreaking havoc on the housing market. Given that it is perhaps the most important asset market in the world, they have real concerns about upsetting equilibrium in this market. Of course, this is a problem of their own making (see 1% Fed Funds in 2003), but that's water under the bridge.

4) Because most people have mortgages which are deep out of the money (see 1% Fed Funds in 2003), the Fed may not have much power to do anything about a housing crash even if they wanted to. If there is a real crash, and it coincides with a rise in home mortgage defaults, this has serious implications for the banking industry.

5) So the best course of action is to hold rates right where they are for a long while, and allow the economy to get used to this level of interest rates. Home prices will correct a bit, but as incomes rise over time, so will activity in the housing market. Corporations will have a better handle on borrowing costs when making long-term plans. The curve will steepen, bringing back the carry trade and improving profits at banks. The Fed maintains its inflation fighting cred, because it didn't cut rates in a panic after seeing a few ugly data releases.

If that happens, my duration neutral steepener play should work. I'd guess it will result in a mild bear steepener, maybe something of a twist, with the 2-year falling 10-20bps and the 10-year rising 10-20bps.

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