Friday, August 18, 2006

Changing of the guard

After two tepid inflation reports, the bond market now seems to have established a new consensus for where the economy is headed. There is now close to 40bps of inversion between Fed Funds and the 2-year, meaning that the market expects multiple Fed Funds cuts in the near future. If you assume the Fed is cutting, you are also assuming inflation won't be a problem. I respectfully disagree with those who say that the Fed's primary goal is to avoid a recession. The economists at the Fed believe their dual mandate is best served by maintaining long-term price stability first, and allowing unemployment to solve itself over time. We need only to look back at 2001 to see that aggressive rate cuts do not cure unemployment, at least not quickly.

So, for the moment, let's take it as a given that rising inflation is not going to be a problem in 2007. What then should we be looking for over the next 6-12 months? The answer: how weak will the economy get? Weak enough to cause a recession? Weak enough to cause another deflation scare? Is this 1995 or 2001?

A soft landing, more like 1995, will result in only a couple Fed cuts, tighter spreads, and normalized curve. Long-term rates would likely be at or even slightly above current levels.

A deflation scare, more like 2001, would result in many Fed cuts, wider spreads, and a very steep curve. All rates would likely be sharply lower than current levels.

I think it comes down to consumer spending. Do current pressures from rising fuel costs and falling home prices cause consumers to pull back substantially? Or, is the housing market problem more localized and consumers need only to moderate their behavior?

For long-term investors, there is more risk being short duration here. The chance of sharply lower rates far outweighs the chance of sharply higher rates. The best bet is probably on a steeper curve, since eventually we know the curve will normalize, so while a deeper inversion is possible, it will be temporary.

1 comment:

Accrued Interest said...

I'm thinking more in terms of economic growth and less in terms of market reaction when I compare now to either 1995 or 2001. Monetary conditions are not as tight now as they were in 1994, and we have no stock market crash to deal with as we did in 2000. So conditions are not really the same as either of those periods.

I agree with you that if the Fed wants to create stimulative monetary policy, it needs to cut the hell out of rates. But I still think that makes betting on a steepener the best bet. If they never cut, we get a bear steepener. If they cut like all hell, we get a bull steepener.