Wednesday, August 09, 2006

The Morning After

Treasury market is weaker overnight. 10-year is down 6 ticks, 30-year down 3/8. Its a little bit of a steepener, so I'd say this has a lot to do with the street building a concession into the auctions over the next two days.

Corporates and MBS liked the Fed's statement, as spreads were generally tighter. Spread product would prefer to see a long period where the Fed stays out of the picture.

Rethinking price action yesterday, with the 2-year rallying and the long-end flat/lower, I wonder if it wasn't curve trades that dominated trading. I had thought there were too many bulls in the market generally, but yesterday looked like traders unwinding flattener trades.

We'll see how this auction goes. I'm happy to continue with a short bet on the 10-year. There just isn't any upside.

1 comment:

CrossProfit said...

Many editorials have expounded upon Chairman Bernanke’s academic background. Most have insinuated that this is a negative quality that must result in a temperament unbefitting the task laden upon his shoulders.

The consensus at CrossProfit is that the pause in the Fed’s tightening cycle was correct. Big Ben got his timing right – hence; the complimentary nickname.

As an academic, Big Ben must have read Stanley Fish’s 2003 piece in the Chronicle of Higher Education regarding the role of higher education. Fish argues that the role is to educate – teaching and research – period. Nothing else! Not politics, religion, morality etc. Fish wrote;

"My concern, however, is not with academic time management but with academic morality, and my assertion is that it is immoral for academics or for academic institutions to proclaim moral views.
The reason was given long ago by a faculty committee report submitted to the president of the University of Chicago. The 1967 report declares that the university exists "only for the limited ... purposes of teaching and research," and it reasons that "since the university is a community only for those limited and distinctive purposes, it is a community which cannot take collective action on the issues of the day without endangering the conditions for its existence and effectiveness."

As an academic, Bernanke knows this. The Federal Reserve exists only for the limited purpose of maintaining stable economic conditions for the United State of America. Nothing else! Not globalization, politics, commodities, emerging markets etc.

With regard to education, obviously all issues impinge on various aspects of the academic world. These effects are to be negated by the faculty and not endorsed or acted upon less academia loses sight of their primary objective. Likewise all non U.S. economic issues contribute their influence on the stability of the American economy. It is the mission of the Federal Reserve to annul any (negative) consequence and steer the economy in the right direction.

The only effective tool at Big Ben’s disposal is setting the Federal funds interest rate. Capitalism takes over from there.
What some don’t realize yet is that Big Ben is an ardent student of Benjamin Disraeli, former prime minister of Great Britain. Though Disraeli started his political career on the left he gradually migrated away from his childhood upbringing and literally invented the new conservative. In a nut shell, neocon Big Ben, while aspiring to employ progressive methods to improve and move things forward, simultaneously reveres the teachings of the past and draws upon the successes and shortcomings of his predecessor. (O.K., go ahead and bring up the Maria incident. You know she got lucky and it won’t happen again.)

It is not within the scope of this article to fully analyze all the ingredients that led to this decision. What is more important is what the ‘pause’ decision really means. In a previous article, we posted a gloomy picture for the future of the U.S. economy;

“ …coupled with the U.S. unabated appetite for oil. The real problem is that no matter how you look at the figures the U.S. economy is in a Catch 22 situation.

If consumers start spending less then business earn less then hire less then there are less consumers spending less and so on and so forth. The result is a recession.

The flip side is that if consumers start spending more then business start earning more but if they hoard the cash or even distribute the profits to the wealthy, eventually the consumer goes bust and then you don’t have a recession instead you have a depression.

If businesses increase wages and reduce their profits then investors will look elsewhere and there will be no new job creation and you end up with stagnation.

If businesses increase wages and then raise prices to refill the company’s coffers then you end up with inflation.

The real killer is if at the same time that wages increase the currency devalues or raw materials and/or finished goods increase and interest rates and unemployment explode and you end up with stagflation.

Recession, depression, stagnation, inflation and stagflation… matter how you cut it the current situation doesn’t look good. There is however a way out. The objective is to maintain current levels of business activity as a whole perhaps even manage a slight increase in line with inflation and reduce consumer debt.

The first dose of reality is to understand that no economy can maintain a 66% consumption rate. The ideal situation is that production equals consumption. If you don’t produce then you should not consume. The notion that supply side economics can spur economic growth indefinitely is bogus. Eventually you accumulate so much debt that everything goes kaput. Supply side economics works great for getting an economy out of a recession. Once achieved, the emphasis should be on production of goods consumed…”

In another previous article from 5/17/06 we wrote;

“Rising interest rates can be a double edge sword for the economy and equities. If the Fed increases to fast, the outcome can lead to accelerated inflation coupled with slower economic activity. This would be a double whammy for oil consumption and the economy.

The Fed tries to be one step ahead based on the economic data. I would give Bernanke credit that he foresaw the core inflation increase. This is the outcome of previously released economic data resulting in the last increase and Bernanke’s last comments alluring to the necessity of one more increase before pausing for evaluation. Yes, even the Fed has to pause in order to allow the markets to realign…”

Now let’s put the two articles together for this is exactly what the Federal Reserve has addressed. Aforementioned there are may ingredients that the Federal Reserve has to measure and get their potency correct. For now we will suffice with housing, energy and the twin deficits (Federal deficit and trade deficit).

If you listened to what Chairman Bernanke has been saying from day one it was obvious he was going to deal with the issues sequentially as listed above.

Supply side economics averted a deep recession that was most likely in the cards prior to 9/11. One of the side effects was an undesirable surplus of liquidity not being invested in the right places; at least not the right places as far as the macro economy was concerned.

The money had to go somewhere, and this in turn led to what is dubbed the housing bubble. Regardless of supply and demand, housing prices were increasing almost everywhere.

Former Chairman Greenspan started the tightening cycle with the intention to bring the housing market back to norm. Reminder; the tightening cycle began way before $60 a barrel of oil. Energy and inflation were non factors at the time. (Remember the deflation concerns?)

Today with interest rates at 5.25%, regions with high demand continue to appreciate, albeit at a slower pace. Regions with an oversupply are decreasing in value and will continue to do so – gradually - until they find their market support level. Mission accomplished.

This is where we are now. Both the global and U.S. inflation stems from the high cost of energy. Remove this obstacle and commodity, wages and you name it inflation dissipates into thin air. There is no shortage of labor or basic commodities, hence supply/demand related pricing is not at play. What is at play is the cost of energy causing the U.S. to print more Dollars (in a round about way) thus reducing the value, in return causing prices to go up…and we have to get off this merry-go-round.

Hypothetically if oil were to drop to $45 a barrel tomorrow the Fed could actually lower interest rates to 5.00% without any adverse effects on the housing market or the economy as a whole.

Big Ben knows that if he were to increase rates by another ¼% this would have no effect on the price of oil. In fact if the Fed were to increase rates another 10 times, each time by a ¼% it would have no effect on the price of oil.

Zero, zilch, nada!

The price of oil would simply adjust slowly and accordingly upwards. The Fed does not have a conventional tool at its disposal to deal with the cost of energy. The White House does but we doubt that this administration will implement the necessary steps. This is a topic for an entirely separate article that deals with the twin deficits as well.

What the Fed could do yet wants to avoid at all cost is use its nuclear arsenal. The only immediate way the Fed can wipe out energy related inflation is by forcing a decrease in consumption sufficient enough to create an oil glut. A bomb = recession.

This is precisely what Big Ben is saying to the White House. The ball is in your court. From a macro perspective, there is no problem leaving rates exactly where they are now until the end of the year. The Federal Reserve is going to maintain a low profile giving the White House several months of rate stability in order not to hinder efforts.

If towards the end of the year the energy issue has not been dealt with either by external events (wishful thinking) or by the Bush administration, then we should all expect a 50/75 point hike. No economy will escape the scorching effects of a global recession. Preventing a U.S. recession is the top priority for all.

Should the interest rate spike occur it will be our first and last notice of things to come.

Disclosure: This is the consensus of the CrossProfit (IL) analyst team. Reference to the White House is not meant to be taken in a ‘Bush bashing’ context.