It sure feels like there are two camps about where the economy is going, and incoming data is only causing parties in both camps to harden their positions.
Today we have personal income and personal spending. Personal income growth for September came in a fairly strong +0.5%. Incomes are up a healthy 6.8% YoY (3.9% in real terms), which is well above the 20-year average of 5.5% (or 2.8% in real terms). Those thinking the economy is still strong and inflation is a concern can point to strong income growth.
Consumer spending is a different story. It grew a meager 0.1% for September. Consumer spending has risen 5.5% over the last 12-months, below the 20-year average of 6%. Real consumer spending is up 3.4% YoY, which is right on the long-term average.
I look at this data and see at worst a modest slowdown. Consumers spend about a year paying down some of the debt they incurred during the housing boom, then its back to spending as usual. The savings rate right now is -0.2%. If we assume consumers "want" to have a savings rate around 1%, income is growing at 7% (nominal) per year, spending can grow at a 5.8% (nominal) rate over the next year, then resume growing at 7% thereafter. That'd be around 3% spending growth in real terms, only about 0.4% weaker than the long-term average. If we take the rule of thumb that 70% of the economy is consumer driven, that's about a 0.3% ding against real GDP.
I don't see the Fed cutting if this is how it plays out as I just described. But that description is a little overly simplistic. We know there are some housing-related challenges looming. The Calculated Risk blog argues that the impact from weak housing is yet to be felt, both because construction job losses will accelerate and because mortgage equity withdrawal (MEW) with continue to decline.
How far MEW falls depends entirely on how severe the housing correction turns out to be. To me, if income continues to climb, the glut of home inventories will work it self out without needing deep declines in home prices. So MEW settles in around +$200 billion, which is where it was in the late 1990's. That's a decline of around $300 billion from where it was in the 2nd quarter, or 2.2% of GDP. I'm using Federal Reserve figures here: estimates of MEW vary greatly. Anyway, the Fed thinks about half of MEW feeds into GDP, so a decline in MEW probably weighs on GDP to the tune of 1.1%.
Would the Fed cut in response to a 1.1% decline in GDP? Probably, but if they estimated that the impact was a one-off, its not going to be an aggressive campaign. In other words, if the impact of MEW is -1.1% in 2007 but its clear the housing market has stabilized, income and spending are growing, I can't see the Fed cutting more than 50bps or so. To do more would risk inflation at a time when the economy is on an upswing.
Monday, October 30, 2006
Credit where credit is due
Goldman Sachs, Merrill Lynch, and Bear Stearns all saw their credit rating upgraded by S&P on Friday. I've made no secret that I like brokerage bonds (here and here), and will disclose right now that my clients own various issues from all three of these firms.
Why the upgrade? All three companies are making money hand over fist despite the inverted yield curve that was supposed cause them so much trouble. In the last 5 years, the list of events that could have hurt the brokerage business are many:
Why the upgrade? All three companies are making money hand over fist despite the inverted yield curve that was supposed cause them so much trouble. In the last 5 years, the list of events that could have hurt the brokerage business are many:
- Bear market in stocks in 2000-2002.
- "Research" scandal.
- Post-bear market weakness in IPO market.
- Argentina default in 2001.
- Post-depression records set in corporate bond defaults in 2001 (source: S&P). 2002 was #2 and 2000 was #3.
- Deflation scare in 2003.
- REFCO collapse in 2005.
- Inverted yield curve in 2005-2006.
But the fact is, the big brokers continue to reap impressive profits. The ratings agencies are finally getting the clue that the brokerage business is more diversified than it was 20 years ago. That the increased leverage these firms are taking on is appropriate, given their ability to manage risk. Could something happen? Some sort of contagion event? Sure. But the same could be said for any company.
A lot is made about the world being more linked together today than in years past. An economic event in Asia or Latin America is no longer a local issue, but has worldwide implications. One thing that isn't talked much about, is the flip side of that statement. That because investors are involved in situations all over the world, that risk has become more spread out. For example, whereas once banks owned most of the risk in the consumer mortgage market, today that risk can be securitized or sold off in the form of CDS. So now, various investors will suffer a small amount if consumer mortgages go bad, rather than the pain being concentrated among a smaller number of financial intermediaries. Contagion risk is lower than most people think.
Friday, October 27, 2006
Some REAL bond trader shit...
On Wednesday I made an off-handed comment that I'd probably be moving to a more neutral position on MBS from an overweight. Steve Feiss made a nice comment on my MBS idea, so I thought I'd flesh out my philosophy on MBS.
Now, I warn you, I spend a lot of time talking about interest rates on this blog. That's something that most people involved in the investment business follow and enjoy reading. Today's post is some real bond trader shit, that probably Steve Feiss and 1-2 other readers will care about. I'm probably looking at the lowest number of hits in months. What the hell, its my blog.
Scott Simon, head of MBS trading at PIMCO, once said that investment managers could add or subtract more alpha in MBS than any other sector, including corporates. I'd say anecdotally that very few investment managers would agree with that. But I know I have added far more value in my career through MBS trading than other sectors. And it hasn't been through aggressive trading. In fact, I'd say that maybe 20% of the MBS positions I've taken over the years were sold before simply paying off.
MBS are extremely complicated on one hand. If you buy a 30-year pass-through with 100 loans in it, then you've really bought 100 30-year non-call 0 loans. That's bond lingo for saying that you really own 100 different loans with 30-years to maturity that can be called at any time (ergo, non-call for zero years). But unlike, say an agency bond structured as a 30-year non-call 0, each of the 100 borrowers may or may not prepay their mortgage for non-economic reasons. Plus a portion of the loan's principal is repaid each month, so while there is technically 30-years to maturity, even with no prepayments most of the principal in the MBS will be repaid well before 30-years.
Many investors attack MBS from an OAS framework. I am dead-set against this. OAS vastly over simplifies a mortgage holders decision making. I've never seen an OAS model that didn't either A) assume a mortgage holders prepayment decision was entirely economic, B) make a blanket assumption about the impact of various characteristics of the underlying loans, or C) assume that prepayments due to "life events," such as moving to another city, occur "normally." So the result is the foundation of the OAS model is built upon assumptions that everyone knows are invalid! By this I mean that A) we know the decision isn't entirely economic, B) we know that the impact of loan characteristics are not consistent from one economic cycle to the next, and C) home mobility is greatly impacted by economic cycles and home price appreciation, so its not likely to occur in a smooth pattern. On top of this shaky foundation of assumptions, OAS models layer on more assumptions about how prepayments will shift due to movements in rates. Again, prepayment models are full of assumptions that everyone knows are invalid.
But if we separate what we know about MBS from what we don't know, the sector becomes rather simple. We know what the coupon rate is on a MBS. We also know that in the course of time, rates are likely to fall such that the underlying loans have a refinancing opportunity. That assumption might be questionable for a small segment of MBS with extremely low coupons, but it holds for most. We also know that in the course of time, most people move out of their current residence.
So what can we do with what we know here? If we figure that eventually a given MBS will come into the money (i.e., refinancable), we can assume that a large percentage of the MBS holders will prepay their loan at that time. We don't know when this might happen or what percentage of the holders will prepay, but we can vary both those factors enough to see the range of likely returns for the security. All we do is assume a small percentage of the loan will prepay in each period up until the time that it becomes refinancable, at which point prepayments will spike.
We then compare that to alternatives, bearing in mind that if the MBS has moved in the money, that alternative bonds would also enjoy capital gains. Typically, the MBS position pays a lot more in yield than other options, but in a rally is likely to substantially underperform. If using this methodology, you find a particular coupon/term structure is way overvalued, you can bet that its a structure that happens to look good in a lot of OAS models, but would break down in a refi spike.
The real skill then becomes seeing if you can find particular MBS that are likely to prepay more favorably than a generic. For example, let's say that you buy a premium priced MBS, so one that would perform terribly in a near-term refi spike. You might be able to find a particular pool where the underlying loan rate is below average for that coupon. For example, a typical 6.5% coupon MBS would have an underlying loan rate of 7%. But its possible to find bonds with an underlying loan rate as low as 6.75%. While we don't know what interest rates are going to do, we know that at any interest rate level, the 6.75% bond will have a lower refi incentive than a typical bond with the same coupon. The funny thing about it is, you rarely if ever have to pay a premium for what is an obviously superior security.
A similar story exists for other loan characteristics, such as average credit score, loan size, geographic distribution, etc. Granted, its a little more difficult to assume how these factors will impact prepayments, but since you can usually buy MBS with these characteristics at the same price as generic bonds, you are in essence making a bet without putting any money in. It almost has to work in your favor over the long run.
For example, I recently added some 30-year 5.5% coupon bonds. These are trading in the $98 range, so what I want to avoid is these bonds paying slower than average. In this market, its widely believed that the "life event" prepayments will occur slower because home price appreciation is down. The logic is that if a borrower doesn't have the cash to put down on a new house because his current house hasn't appreciated, he won't be able to move.
So if I buy a discount MBS, I want to find bonds that won't have the home price appreciation problem. That would include older loans, because those borrowers have already enjoyed some home price appreciation, and loans where the borrower is on strong financial footing. You can tell by looking for high credit scores, larger loans, and a loan-to-value below 80%. (The opposite of loan-to-value is equity, so a LTV of 65% means the borrower has 35% equity). I have no problem finding 30-year 5.5% MBS which are 6-12 months old, and appear to be full of loans given to borrowers with strong finances. And I paid nothing over generic MBS. If it turns out that these bonds don't pay a cent faster than generic, no harm no foul. But if they do, that's adding alpha.
Now, I warn you, I spend a lot of time talking about interest rates on this blog. That's something that most people involved in the investment business follow and enjoy reading. Today's post is some real bond trader shit, that probably Steve Feiss and 1-2 other readers will care about. I'm probably looking at the lowest number of hits in months. What the hell, its my blog.
Scott Simon, head of MBS trading at PIMCO, once said that investment managers could add or subtract more alpha in MBS than any other sector, including corporates. I'd say anecdotally that very few investment managers would agree with that. But I know I have added far more value in my career through MBS trading than other sectors. And it hasn't been through aggressive trading. In fact, I'd say that maybe 20% of the MBS positions I've taken over the years were sold before simply paying off.
MBS are extremely complicated on one hand. If you buy a 30-year pass-through with 100 loans in it, then you've really bought 100 30-year non-call 0 loans. That's bond lingo for saying that you really own 100 different loans with 30-years to maturity that can be called at any time (ergo, non-call for zero years). But unlike, say an agency bond structured as a 30-year non-call 0, each of the 100 borrowers may or may not prepay their mortgage for non-economic reasons. Plus a portion of the loan's principal is repaid each month, so while there is technically 30-years to maturity, even with no prepayments most of the principal in the MBS will be repaid well before 30-years.
Many investors attack MBS from an OAS framework. I am dead-set against this. OAS vastly over simplifies a mortgage holders decision making. I've never seen an OAS model that didn't either A) assume a mortgage holders prepayment decision was entirely economic, B) make a blanket assumption about the impact of various characteristics of the underlying loans, or C) assume that prepayments due to "life events," such as moving to another city, occur "normally." So the result is the foundation of the OAS model is built upon assumptions that everyone knows are invalid! By this I mean that A) we know the decision isn't entirely economic, B) we know that the impact of loan characteristics are not consistent from one economic cycle to the next, and C) home mobility is greatly impacted by economic cycles and home price appreciation, so its not likely to occur in a smooth pattern. On top of this shaky foundation of assumptions, OAS models layer on more assumptions about how prepayments will shift due to movements in rates. Again, prepayment models are full of assumptions that everyone knows are invalid.
But if we separate what we know about MBS from what we don't know, the sector becomes rather simple. We know what the coupon rate is on a MBS. We also know that in the course of time, rates are likely to fall such that the underlying loans have a refinancing opportunity. That assumption might be questionable for a small segment of MBS with extremely low coupons, but it holds for most. We also know that in the course of time, most people move out of their current residence.
So what can we do with what we know here? If we figure that eventually a given MBS will come into the money (i.e., refinancable), we can assume that a large percentage of the MBS holders will prepay their loan at that time. We don't know when this might happen or what percentage of the holders will prepay, but we can vary both those factors enough to see the range of likely returns for the security. All we do is assume a small percentage of the loan will prepay in each period up until the time that it becomes refinancable, at which point prepayments will spike.
We then compare that to alternatives, bearing in mind that if the MBS has moved in the money, that alternative bonds would also enjoy capital gains. Typically, the MBS position pays a lot more in yield than other options, but in a rally is likely to substantially underperform. If using this methodology, you find a particular coupon/term structure is way overvalued, you can bet that its a structure that happens to look good in a lot of OAS models, but would break down in a refi spike.
The real skill then becomes seeing if you can find particular MBS that are likely to prepay more favorably than a generic. For example, let's say that you buy a premium priced MBS, so one that would perform terribly in a near-term refi spike. You might be able to find a particular pool where the underlying loan rate is below average for that coupon. For example, a typical 6.5% coupon MBS would have an underlying loan rate of 7%. But its possible to find bonds with an underlying loan rate as low as 6.75%. While we don't know what interest rates are going to do, we know that at any interest rate level, the 6.75% bond will have a lower refi incentive than a typical bond with the same coupon. The funny thing about it is, you rarely if ever have to pay a premium for what is an obviously superior security.
A similar story exists for other loan characteristics, such as average credit score, loan size, geographic distribution, etc. Granted, its a little more difficult to assume how these factors will impact prepayments, but since you can usually buy MBS with these characteristics at the same price as generic bonds, you are in essence making a bet without putting any money in. It almost has to work in your favor over the long run.
For example, I recently added some 30-year 5.5% coupon bonds. These are trading in the $98 range, so what I want to avoid is these bonds paying slower than average. In this market, its widely believed that the "life event" prepayments will occur slower because home price appreciation is down. The logic is that if a borrower doesn't have the cash to put down on a new house because his current house hasn't appreciated, he won't be able to move.
So if I buy a discount MBS, I want to find bonds that won't have the home price appreciation problem. That would include older loans, because those borrowers have already enjoyed some home price appreciation, and loans where the borrower is on strong financial footing. You can tell by looking for high credit scores, larger loans, and a loan-to-value below 80%. (The opposite of loan-to-value is equity, so a LTV of 65% means the borrower has 35% equity). I have no problem finding 30-year 5.5% MBS which are 6-12 months old, and appear to be full of loans given to borrowers with strong finances. And I paid nothing over generic MBS. If it turns out that these bonds don't pay a cent faster than generic, no harm no foul. But if they do, that's adding alpha.
Thursday, October 26, 2006
Suck out
I'm not a big poker player, but I really enjoy the theories behind how the game is played. I think there are a lot of corollaries between a good trader and a good poker player. So let me make a poker analogy to the market action yesterday.
Yesterday I made the following statement: "...sentiment seems pretty bearish so a moderate sounding statement may bring a small rally." And that's exactly what happened. The statement sounded very much like the recent speeches we've seen from various Fed economists. Basically that inflation is too high right now, but a moderately cooling economy should allow the Fed to stay on hold for a while.
So why the rally if every one already knew this was the Fed's position? Because, in poker terms, the bond bears were all in. In poker, when players in front of you have made big bets, and the pot has gotten very large, sometimes the best strategy is to call the bet even if you think you have a less than 50% chance of winning the pot. For example, if the pot has $1,000 in it, and all you had to do was put $100 in to stay in the game, then as long as you have a better than 1/10 chance of winning, its a good bet.
That's what we had yesterday. The bond bears had bet heavily on a very hawkish Fed statement. Therefore, unless the statement was uber-hawkish, the market wasn't going to move much. On the other hand, since no one was betting on a moderate statement, that outcome resulted in a fair-sized rally.
Now, it isn't really my job to make short-term trades like that, so I can't say I made any money on my correct prognostication. But I think it reiterates the idea that you have to both analyze your economic opinion and what the market has priced in. Otherwise, you make lose money while being right all the way.
Yesterday I made the following statement: "...sentiment seems pretty bearish so a moderate sounding statement may bring a small rally." And that's exactly what happened. The statement sounded very much like the recent speeches we've seen from various Fed economists. Basically that inflation is too high right now, but a moderately cooling economy should allow the Fed to stay on hold for a while.
So why the rally if every one already knew this was the Fed's position? Because, in poker terms, the bond bears were all in. In poker, when players in front of you have made big bets, and the pot has gotten very large, sometimes the best strategy is to call the bet even if you think you have a less than 50% chance of winning the pot. For example, if the pot has $1,000 in it, and all you had to do was put $100 in to stay in the game, then as long as you have a better than 1/10 chance of winning, its a good bet.
That's what we had yesterday. The bond bears had bet heavily on a very hawkish Fed statement. Therefore, unless the statement was uber-hawkish, the market wasn't going to move much. On the other hand, since no one was betting on a moderate statement, that outcome resulted in a fair-sized rally.
Now, it isn't really my job to make short-term trades like that, so I can't say I made any money on my correct prognostication. But I think it reiterates the idea that you have to both analyze your economic opinion and what the market has priced in. Otherwise, you make lose money while being right all the way.
Wednesday, October 25, 2006
Lonely morning on trading floors
Not much to talk about in front of the Fed today. The market is very quiet waiting to see what the Fed statement will say. Probably not much, but sentiment seems pretty bearish so a moderate sounding statement may bring a small rally. Fed Funds futures now price in a ~15% chance of a hike in January, which is a sharp contrast to a few weeks ago when futures started to price in some chance of a cut at the same time. Still seems like the front end ought sell-off more than where it is. On longer bonds, I'm feeling very neutral. Over the next 12-18 months, I think the curve will develop a more normal slope. Like +25 to +50 between 2-30. But if the Fed indeed hikes one more time, but the market still expects cuts over the long-term, then the inversion will get deeper, at least for now, with the 2-year rising and the 10-30yr area standing still. Unless the Fed actually manufactures a deflationary environment, I think the upside (i.e. declining yields) to the long-end is limited to 25bps or so.
With limited upside, I can't see adding to the long-end of the curve here. I hate positioning my long-term portfolios for relatively small moves, because I'm taking a fair sized risk with my clients money for what I only expect to be a small reward. Also, whether I'm able to capture that small reward depends very greatly on my ability to time the move just right, which is always difficult. Plus, in this market, going out the curve might cost you income generation. Income is a known quantity, and its very hard to give up a known quantity for a possible reward that isn't that big to begin with.
One thing that is worth acting on is my MBS position. MBS will probably cheapen in a deeper inversion scenario, and that puts my MBS overweight at risk. Corporates most likely also get cheaper, but I'm already underweight there.
With limited upside, I can't see adding to the long-end of the curve here. I hate positioning my long-term portfolios for relatively small moves, because I'm taking a fair sized risk with my clients money for what I only expect to be a small reward. Also, whether I'm able to capture that small reward depends very greatly on my ability to time the move just right, which is always difficult. Plus, in this market, going out the curve might cost you income generation. Income is a known quantity, and its very hard to give up a known quantity for a possible reward that isn't that big to begin with.
One thing that is worth acting on is my MBS position. MBS will probably cheapen in a deeper inversion scenario, and that puts my MBS overweight at risk. Corporates most likely also get cheaper, but I'm already underweight there.
Monday, October 23, 2006
What does Greg Ip have against the Treasury market anyway?
Greg Ip of the Wall Street Journal, who is a long rumored Fed mouth piece, has a piece out today saying the Fed could go on hold much longer than in the 1995 period. Regular readers of this blog know I've been making that case for a while now. Ip does bring something fresh to the conversation: how Bernanke's affinity for inflation targeting may influence his actions in ways that didn't Greenspan in 1995.
Under Greenspan, no one knew exactly what the Fed's tolerance was for inflation. Marketeers and policy makers could broadly agree that core CPI at 4%, as it was when Greenspan took over, was too high. But as former president of the Atlanta Fed Robert Forrestal said (quoted by Ip): "We talk about price stability and lower inflation, and inflation being quiescent, and so on, but I don't know what our level of tolerance is." Dr. Greenspan believed in judgment over econometrics. He believed the economy and markets were driven by emotional human beings. Check out this quote from a recent interview with Sherry Cooper of Nesbitt Burns.
"Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgment is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it's practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren't for Ayn Rand."
So if we follow Greenspan's idea of judgment over rigid rules, it stands to reason that he'd not want to give hard numbers on where he wanted inflation to be.
Bernanke is a man of evidence. The evidence points strongly to the value of inflation targeting. Read this panel discussion from the summer of 2004: it's a roadmap to how Bernanke is operating today. So while it might be politically sensitive for the Fed to create a statutory inflation target, de facto, we already have one. As soon as Fed economists publicly start throwing around ranges like 1.5% to 2.5%, for all intents and purposes, that's the inflation target.
For what its worth, I am a man of evidence as well. I've read the evidence for and against inflation targeting, and I find the evidence favors the target. But really, for someone in my profession, its besides the point as to whether the inflation target is good for the economy in the long run. The fact is, for the near term at least, the Fed is going to focus on keeping core PCE between 1.5% and 2.5%.
So to bet that the Fed is going to act like it did in 1995 is to assume that two very different philosophies about how to run the Fed will come to the same conclusion. If that happens, then it will be by coincidence. 1995, in my mind, should clearly not be used as evidence for what's going to happen in 2007.
Under Greenspan, no one knew exactly what the Fed's tolerance was for inflation. Marketeers and policy makers could broadly agree that core CPI at 4%, as it was when Greenspan took over, was too high. But as former president of the Atlanta Fed Robert Forrestal said (quoted by Ip): "We talk about price stability and lower inflation, and inflation being quiescent, and so on, but I don't know what our level of tolerance is." Dr. Greenspan believed in judgment over econometrics. He believed the economy and markets were driven by emotional human beings. Check out this quote from a recent interview with Sherry Cooper of Nesbitt Burns.
"Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgment is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it's practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren't for Ayn Rand."
So if we follow Greenspan's idea of judgment over rigid rules, it stands to reason that he'd not want to give hard numbers on where he wanted inflation to be.
Bernanke is a man of evidence. The evidence points strongly to the value of inflation targeting. Read this panel discussion from the summer of 2004: it's a roadmap to how Bernanke is operating today. So while it might be politically sensitive for the Fed to create a statutory inflation target, de facto, we already have one. As soon as Fed economists publicly start throwing around ranges like 1.5% to 2.5%, for all intents and purposes, that's the inflation target.
For what its worth, I am a man of evidence as well. I've read the evidence for and against inflation targeting, and I find the evidence favors the target. But really, for someone in my profession, its besides the point as to whether the inflation target is good for the economy in the long run. The fact is, for the near term at least, the Fed is going to focus on keeping core PCE between 1.5% and 2.5%.
So to bet that the Fed is going to act like it did in 1995 is to assume that two very different philosophies about how to run the Fed will come to the same conclusion. If that happens, then it will be by coincidence. 1995, in my mind, should clearly not be used as evidence for what's going to happen in 2007.
What does Greg Ip have against the Treasury market anyway?
Greg Ip of the Wall Street Journal, who is a long rumored Fed mouth piece, has a piece out today saying the Fed could go on hold much longer than in the 1995 period. Regular readers of this blog know I've been making that case for a while now. Ip does bring something fresh to the conversation: how Bernanke's affinity for inflation targeting may influence his actions in ways that didn't Greenspan in 1995.
Under Greenspan, no one knew exactly what the Fed's tolerance was for inflation. Marketeers and policy makers could broadly agree that core CPI at 4%, as it was when Greenspan took over, was too high. But as former president of the Atlanta Fed Robert Forrestal said (quoted by Ip): "We talk about price stability and lower inflation, and inflation being quiescent, and so on, but I don't know what our level of tolerance is." Dr. Greenspan believed in judgment over econometrics. He believed the economy and markets were driven by emotional human beings. Check out this quote from a recent interview with Sherry Cooper of Nesbitt Burns.
"Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgment is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it's practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren't for Ayn Rand."
So if we follow Greenspan's idea of judgment over rigid rules, it stands to reason that he'd not want to give hard numbers on where he wanted inflation to be.
Bernanke is a man of evidence. The evidence points strongly to the value of inflation targeting. Read this panel discussion from the summer of 2004: it's a roadmap to how Bernanke is operating today. So while it might be politically sensitive for the Fed to create a statutory inflation target, de facto, we already have one. As soon as Fed economists publicly start throwing around ranges like 1.5% to 2.5%, for all intents and purposes, that's the inflation target.
For what its worth, I am a man of evidence as well. I've read the evidence for and against inflation targeting, and I find the evidence favors the target. But really, for someone in my profession, its besides the point as to whether the inflation target is good for the economy in the long run. The fact is, for the near term at least, the Fed is going to focus on keeping core PCE between 1.5% and 2.5%.
So to bet that the Fed is going to act like it did in 1995 is to assume that two very different philosophies about how to run the Fed will come to the same conclusion. If that happens, then it will be by coincidence. 1995, in my mind, should clearly not be used as evidence for what's going to happen in 2007.
Under Greenspan, no one knew exactly what the Fed's tolerance was for inflation. Marketeers and policy makers could broadly agree that core CPI at 4%, as it was when Greenspan took over, was too high. But as former president of the Atlanta Fed Robert Forrestal said (quoted by Ip): "We talk about price stability and lower inflation, and inflation being quiescent, and so on, but I don't know what our level of tolerance is." Dr. Greenspan believed in judgment over econometrics. He believed the economy and markets were driven by emotional human beings. Check out this quote from a recent interview with Sherry Cooper of Nesbitt Burns.
"Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgment is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it's practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren't for Ayn Rand."
So if we follow Greenspan's idea of judgment over rigid rules, it stands to reason that he'd not want to give hard numbers on where he wanted inflation to be.
Bernanke is a man of evidence. The evidence points strongly to the value of inflation targeting. Read this panel discussion from the summer of 2004: it's a roadmap to how Bernanke is operating today. So while it might be politically sensitive for the Fed to create a statutory inflation target, de facto, we already have one. As soon as Fed economists publicly start throwing around ranges like 1.5% to 2.5%, for all intents and purposes, that's the inflation target.
For what its worth, I am a man of evidence as well. I've read the evidence for and against inflation targeting, and I find the evidence favors the target. But really, for someone in my profession, its besides the point as to whether the inflation target is good for the economy in the long run. The fact is, for the near term at least, the Fed is going to focus on keeping core PCE between 1.5% and 2.5%.
So to bet that the Fed is going to act like it did in 1995 is to assume that two very different philosophies about how to run the Fed will come to the same conclusion. If that happens, then it will be by coincidence. 1995, in my mind, should clearly not be used as evidence for what's going to happen in 2007.
Thursday, October 19, 2006
Homes in Hock
Moody's Economy.com and Equifax reported that the percentage of home loans now delinquent has increased to 2.33% in the third quarter, up from a mere 0.30% in the fourth quarter of 2005. The study estimates that mortgage equity withdrawal is the driving factor for delinquencies in most metro areas. In other words, most delinquencies have been caused by over leveraging. Which really can be tied to weaker credit standards on the part of mortgage lenders. This article in the Wall Street Journal also mentions a survey by the OCC indicating that banks have generally been loosening credit standards over the last year.
I have been following a different data series on mortgage delinquencies, this one by the Mortgage Bankers Association. Its most recent release was from the 2nd quarter and showed 4.39% of loans were delinquent. I'm not sure what the methodology difference is between these two time series, but my suspicion is its either related to the definition of delinquent (i.e., 30 days past due, 90 days past due) or whether one survey is based on percentage of loans vs. percentage of dollars lent. I'm contacting the MBA to see what their methods are. Moody's is real bitchy about telling you anything without you paying for their services. Capitalist pigs.
Anyway, here is the chart on the MBA series. Doesn't look like much to worry about if you are an investor in consumer ABS.
The pink line is the long-term average. So one time series looks like delinquencies are rising and another looks like they are stable. Stay tuned.
One interesting note that is mentioned only briefly in the WSJ article: how much of delinquencies are made up of investors? I've got to think there are a lot of homes that were bought by amateur or professional flippers who have gone bust. That sort of delinquency is very different than regular Joe's delinquency. If I owned 5 properties and I go bust, then that's 5 delinquent loans, but only one person's consumption that is impacted. Just a thought.
UPDATE -- 2:56PM
Ruth Simon of the Wall Street Journal clued me in on one difference between these two studies. The Economy.com/Equifax took a sample of credit reports whereas the MBA asked member banks to report on delinquencies. I'm still not sure why one would be fundamentally different from the other, but they are.
As an aside, props to the WSJ writers. I've written a few of them over the years to ask questions about their articles and have always received prompt and informative responses. Having access to that kind of help is a significant asset for me, and a good reason why I subscribe to both the online and print versions.
I have been following a different data series on mortgage delinquencies, this one by the Mortgage Bankers Association. Its most recent release was from the 2nd quarter and showed 4.39% of loans were delinquent. I'm not sure what the methodology difference is between these two time series, but my suspicion is its either related to the definition of delinquent (i.e., 30 days past due, 90 days past due) or whether one survey is based on percentage of loans vs. percentage of dollars lent. I'm contacting the MBA to see what their methods are. Moody's is real bitchy about telling you anything without you paying for their services. Capitalist pigs.
Anyway, here is the chart on the MBA series. Doesn't look like much to worry about if you are an investor in consumer ABS.
The pink line is the long-term average. So one time series looks like delinquencies are rising and another looks like they are stable. Stay tuned.
One interesting note that is mentioned only briefly in the WSJ article: how much of delinquencies are made up of investors? I've got to think there are a lot of homes that were bought by amateur or professional flippers who have gone bust. That sort of delinquency is very different than regular Joe's delinquency. If I owned 5 properties and I go bust, then that's 5 delinquent loans, but only one person's consumption that is impacted. Just a thought.
UPDATE -- 2:56PM
Ruth Simon of the Wall Street Journal clued me in on one difference between these two studies. The Economy.com/Equifax took a sample of credit reports whereas the MBA asked member banks to report on delinquencies. I'm still not sure why one would be fundamentally different from the other, but they are.
As an aside, props to the WSJ writers. I've written a few of them over the years to ask questions about their articles and have always received prompt and informative responses. Having access to that kind of help is a significant asset for me, and a good reason why I subscribe to both the online and print versions.
Wednesday, October 18, 2006
Its bad, but not THAT bad! Part II
A rebound in housing starts today has the bond market trading mildly weaker. This carries through on a theme I posted about yesterday, where the markets seemed poised for only bad news on the housing market. Even mediocre numbers are causing a significant reaction. I'm guessing that today's housing starts number became priced in yesterday after the NAHB report. I had opined that the NAHB report wasn't enough to warrant the sell-off we got yesterday, but if I had known housing starts would beat expectations, the sell-off makes more sense. So I guess the market traders out-smarted me. It won't be the last time.
Meanwhile, CPI turned out to be uninteresting. The core figure came in right on expectations. Worth noting the Core YoY is now 2.9%, too high for even Dr. Yellen. Since the number is right on expectations, the market isn't moving on it, but if you are bearish on Treasuries, that 2.9% figure certainly reinforces your view. I know it does mine.
Meanwhile, CPI turned out to be uninteresting. The core figure came in right on expectations. Worth noting the Core YoY is now 2.9%, too high for even Dr. Yellen. Since the number is right on expectations, the market isn't moving on it, but if you are bearish on Treasuries, that 2.9% figure certainly reinforces your view. I know it does mine.
Tuesday, October 17, 2006
Its bad, but not THAT bad!
The National Association of Home Builders released their monthly survey today. Its a simple survey that asks home builders to describe their present sales, 6-month sales expectations, and traffic from prospective buyers. The results range from 0-100 with 100 being the best. Over the last 20-years, the number has ranged from 78 (December 1998) to 20 (January 1991) and has averaged 56. Today's figure was 31, up from 30. The late 1990-early 1991 period was the only other time the index was as low as it is now.
The release took all the steam out of the Treasury market: the 10-year finished up 2 ticks after being up more than 10 ticks on the day.
I'm a bit surprised by the market's move. If you think housing prices are going to hurt consumer spending, this release shouldn't change your mind. If you think home builders have been driving the economy and without stimulus from construction the economy sinks, a reading of 31 (8th lowest reading in 20 years) is hardly bearish.
I think this is evidence that the market is overly bearish on housing. If a number like this causes a market rally, then the market was obviously expecting something extremely bearish.
The release took all the steam out of the Treasury market: the 10-year finished up 2 ticks after being up more than 10 ticks on the day.
I'm a bit surprised by the market's move. If you think housing prices are going to hurt consumer spending, this release shouldn't change your mind. If you think home builders have been driving the economy and without stimulus from construction the economy sinks, a reading of 31 (8th lowest reading in 20 years) is hardly bearish.
I think this is evidence that the market is overly bearish on housing. If a number like this causes a market rally, then the market was obviously expecting something extremely bearish.
Data, data, and more data!
Bonds are rallying today, up about 10 ticks on the 10-year. It looks like the reason is the whopping $117 billion in net foreign securities purchases during August, almost 4 times the level in July and twice what was expected.
Meanwhile, core PPI came in a good bit higher than survey (+0.6% vs. +0.2%). The market didn't pay much heed, probably because PPI is so volatile, you can't read much into one number. If, by chance, we get a similar miss from core CPI tomorrow, could result in a serious sell-off.
Less attention was paid to capacity utilization, but this is an important number for many Fed economists. Capacity utilization is simply the percentage of industrial productive capacity that is actually being used. It is generally believed that capacity utilization can only get so high before it becomes inflationary. E.g., to actually run a factory at 100%, you have to be buying an elevated level of raw materials, paying a lot of overtime, etc. Anyway, capacity utilization for September was estimated at 81.9%, which is above the 20-year average of 81.0%. During most periods of sustained Fed cuts, this figure dropped into the 70's.
You may ask, "how useful is capacity utilization in today's economy?" Fair question. Another fair question is "Doesn't this all smack of Keynesian/Phillips Curve type thinking? I thought you were a monetarist?" Touche. So I'm not too high on capacity utilization personally, but if the Fed looks at it, then I look at it.
There remains the slight possibility that the economists who run the Federal Reserve are smarter than me. Maybe.
Meanwhile, core PPI came in a good bit higher than survey (+0.6% vs. +0.2%). The market didn't pay much heed, probably because PPI is so volatile, you can't read much into one number. If, by chance, we get a similar miss from core CPI tomorrow, could result in a serious sell-off.
Less attention was paid to capacity utilization, but this is an important number for many Fed economists. Capacity utilization is simply the percentage of industrial productive capacity that is actually being used. It is generally believed that capacity utilization can only get so high before it becomes inflationary. E.g., to actually run a factory at 100%, you have to be buying an elevated level of raw materials, paying a lot of overtime, etc. Anyway, capacity utilization for September was estimated at 81.9%, which is above the 20-year average of 81.0%. During most periods of sustained Fed cuts, this figure dropped into the 70's.
You may ask, "how useful is capacity utilization in today's economy?" Fair question. Another fair question is "Doesn't this all smack of Keynesian/Phillips Curve type thinking? I thought you were a monetarist?" Touche. So I'm not too high on capacity utilization personally, but if the Fed looks at it, then I look at it.
There remains the slight possibility that the economists who run the Federal Reserve are smarter than me. Maybe.
Monday, October 16, 2006
Groundhog Day in Corporate Spreads
Despite the much ballyhooed fears of corporate bond spreads widening, spreads have been extremely stable in 2006? How stable you ask? Look at the following chart.
The blue line is the OAS for the Merrill Lynch Corporate Master. The yellow line is the 20 day range of the same OAS. So if the widest spread in a 20 trading day period is 90bps and the tightest is 70bps, then range is 20bps. Simple right? I have about 10-years worth of data, which is as much as Merrill Lynch publishes on OAS.
The range over the last 20 days is extremely low: 2bps. So if you had a crystal ball and knew exactly what day was going to have the widest spread and what day would have the tightest, you'd still have a hard time making much money trading the corporate basis.
I'm not sure what to make of this. We don't really have that much data to work with to draw much statistical conclusion. Although it looks like there is a strong correlation between the range and the spread, it looks like that is dominated by the periods of extreme widening. Its simple arithmetic to see that if spreads spike higher the range will get wider. We don't have an example of spreads moving 100bps higher and hanging there.
What that could mean is that there is more of a floor to corporate spreads than there is a ceiling. By this I mean, a corporate bond spread that starts at +100 vs. Treasuries can't go to zero, but can go to +1,000. Investors need to see a certain yield concession to own corporates period, and yield spreads cannot fall beyond this point. So even when corporate fundamentals are very strong, spreads can only tighten so much.
So if that idea is right, and we're in a period where corporate fundamentals are strong but we observe an unwillingness on the part of marketeers to bid up corporates, then maybe we've already hit that floor. This means there is little upside to corporate bonds, and at best you'll collect the extra yield.
So normally we'd expect corporate spreads to tighten as the curve steepens, but it might be different this time.
The blue line is the OAS for the Merrill Lynch Corporate Master. The yellow line is the 20 day range of the same OAS. So if the widest spread in a 20 trading day period is 90bps and the tightest is 70bps, then range is 20bps. Simple right? I have about 10-years worth of data, which is as much as Merrill Lynch publishes on OAS.
The range over the last 20 days is extremely low: 2bps. So if you had a crystal ball and knew exactly what day was going to have the widest spread and what day would have the tightest, you'd still have a hard time making much money trading the corporate basis.
I'm not sure what to make of this. We don't really have that much data to work with to draw much statistical conclusion. Although it looks like there is a strong correlation between the range and the spread, it looks like that is dominated by the periods of extreme widening. Its simple arithmetic to see that if spreads spike higher the range will get wider. We don't have an example of spreads moving 100bps higher and hanging there.
What that could mean is that there is more of a floor to corporate spreads than there is a ceiling. By this I mean, a corporate bond spread that starts at +100 vs. Treasuries can't go to zero, but can go to +1,000. Investors need to see a certain yield concession to own corporates period, and yield spreads cannot fall beyond this point. So even when corporate fundamentals are very strong, spreads can only tighten so much.
So if that idea is right, and we're in a period where corporate fundamentals are strong but we observe an unwillingness on the part of marketeers to bid up corporates, then maybe we've already hit that floor. This means there is little upside to corporate bonds, and at best you'll collect the extra yield.
So normally we'd expect corporate spreads to tighten as the curve steepens, but it might be different this time.
Friday, October 13, 2006
Looking beyond the headline...
Although at first blush, the retail sales report looks ugly, but it turns out that the entire decline is due to lower gas prices. This supports a theory many economic bulls have been touting -- lower gas prices will offset any effect housing prices have on consumer spending. Some of the areas of increased spending are particularly encouraging: eating out +1.0%, furniture +0.2%, electronics +0.2%. These are things consumers wouldn't be buying if their economic situation were dire.
The 10-year has given up 2 points in price and 25bps in yield since 9/25.
The data is becoming less and less supportive of any sort of Fed cut in 2007. Virtually every FOMC member that has spoken in the last 2 weeks has included the following point in their speech:
1) Inflation is above their comfort zone.
2) Impending economic weakness (due in large part to the housing market) will push inflation lower without the need for further rate hikes.
However, if we keep seeing strong retail sales numbers, point #2 is no longer valid. If you don't see weak housing turning into weak consumer spending, then you can't expect it to have any impact on inflation.
I think this brings the possibility of the next move being a hike back into play. Maybe its only a 10% chance. But let's say there is a 10% chance of a hike in March, and 50% chance of no move. You need to expect a 40% chance of 5 rate cuts starting in March to justify where the 2-year is now. The set of information we have available to us doesn't suggest the odds of such an aggressive Fed are 40%.
The 10-year has given up 2 points in price and 25bps in yield since 9/25.
The data is becoming less and less supportive of any sort of Fed cut in 2007. Virtually every FOMC member that has spoken in the last 2 weeks has included the following point in their speech:
1) Inflation is above their comfort zone.
2) Impending economic weakness (due in large part to the housing market) will push inflation lower without the need for further rate hikes.
However, if we keep seeing strong retail sales numbers, point #2 is no longer valid. If you don't see weak housing turning into weak consumer spending, then you can't expect it to have any impact on inflation.
I think this brings the possibility of the next move being a hike back into play. Maybe its only a 10% chance. But let's say there is a 10% chance of a hike in March, and 50% chance of no move. You need to expect a 40% chance of 5 rate cuts starting in March to justify where the 2-year is now. The set of information we have available to us doesn't suggest the odds of such an aggressive Fed are 40%.
Thursday, October 12, 2006
Sherman threatens to burn down Greenwich too
With not much happening in the bond market, I though I'd comment on the swirling debate about whether private equity companies may be breaking anti-trust law. Nothing to do with bonds, you say? Hey, its my blog.
OK first, I'm not a lawyer. So I'm attacking this problem from the perspective of an economist. So the question is does the collusive activity result in economic harm? So it may be that someone has or has not broken the letter of the law, but for the sake of discussion, let's assume the law is actually related to real economic harm. Hey, its fun to pretend right?
I'll admit my biases up front. I normally have a dim view of anti-trust cases. The history of anti-trust law is full of examples of cases being brought against companies because their competitors complained, not because real harm to consumers could be found.
But let's take the case of private equity with an open mind. The query by anti-trust officials is about how private equity groups go about bidding on potential buyouts. As the linked WSJ article states, if buyout funds were colluding to say "I'll bid on this deal, you bid on that," then we have an obvious case of harm done to shareholders. Let's assume that isn't happening for a moment.
We know that companies contemplating going private can't hold a public auction for themselves. The terms are generally too complicated. Plus, a company may want to explore the possibility of going private without market scrutiny. Let's say that a company thinks it could go private at a 7% premium to the current stock price, but management believes that at some point in the future, a 15% premium could be commanded. If it became publicly known that the company was considering a buyout, shareholder sentiment may wind up forcing a (premature) move.
We also know that sometimes private equity targets a company. In that case, the private equity company isn't going to let it be known who they are targeting, so there isn't any chance for competing offers until after the private equity firm actually makes an offer. At that point, its possible that negotiations have been ongoing for some time, so the group that made the initial offer has a clear advantage over other groups trying to make competing bids. That isn't to say that another bid can't win, but that someone has an advantage.
No matter who seeks out whom, the incentives for both sides are clear. The public company wants the highest possible price, and the private equity wants the lowest possible price. So if a company looking to go private gets a poor price, its most likely a result of poor negotiation and/or a lack of awareness about what their company is really worth. Incompetence is not illegal.
Let's say two buyout funds were thinking of both making a bid for a company, but decided instead to join up and bid lower. I'm not sure whether that would be illegal or not under present statutes, but at any rate, it seems as though its still on the company to negotiate the best price possible.
If anyone disagrees I'd love to hear your comments. As long as the comment isn't something like "Let's take down the big, bad, private equity market."
OK first, I'm not a lawyer. So I'm attacking this problem from the perspective of an economist. So the question is does the collusive activity result in economic harm? So it may be that someone has or has not broken the letter of the law, but for the sake of discussion, let's assume the law is actually related to real economic harm. Hey, its fun to pretend right?
I'll admit my biases up front. I normally have a dim view of anti-trust cases. The history of anti-trust law is full of examples of cases being brought against companies because their competitors complained, not because real harm to consumers could be found.
But let's take the case of private equity with an open mind. The query by anti-trust officials is about how private equity groups go about bidding on potential buyouts. As the linked WSJ article states, if buyout funds were colluding to say "I'll bid on this deal, you bid on that," then we have an obvious case of harm done to shareholders. Let's assume that isn't happening for a moment.
We know that companies contemplating going private can't hold a public auction for themselves. The terms are generally too complicated. Plus, a company may want to explore the possibility of going private without market scrutiny. Let's say that a company thinks it could go private at a 7% premium to the current stock price, but management believes that at some point in the future, a 15% premium could be commanded. If it became publicly known that the company was considering a buyout, shareholder sentiment may wind up forcing a (premature) move.
We also know that sometimes private equity targets a company. In that case, the private equity company isn't going to let it be known who they are targeting, so there isn't any chance for competing offers until after the private equity firm actually makes an offer. At that point, its possible that negotiations have been ongoing for some time, so the group that made the initial offer has a clear advantage over other groups trying to make competing bids. That isn't to say that another bid can't win, but that someone has an advantage.
No matter who seeks out whom, the incentives for both sides are clear. The public company wants the highest possible price, and the private equity wants the lowest possible price. So if a company looking to go private gets a poor price, its most likely a result of poor negotiation and/or a lack of awareness about what their company is really worth. Incompetence is not illegal.
Let's say two buyout funds were thinking of both making a bid for a company, but decided instead to join up and bid lower. I'm not sure whether that would be illegal or not under present statutes, but at any rate, it seems as though its still on the company to negotiate the best price possible.
If anyone disagrees I'd love to hear your comments. As long as the comment isn't something like "Let's take down the big, bad, private equity market."
Wednesday, October 11, 2006
Minutes and Lacker
The minutes of the September 20 FOMC meeting were released today. In my opinion, there isn't much here that wasn't already said in recent Fed Head speeches. Bottom line: inflation is too high, but may subside on its own from here, both because of economic weakness and the cumulative effect of rate hikes heretofore. The market took it as bad news, as the 10-year is currently down 6 ticks on the day, when it had been up as much as 1/4.
Richmond Fed President Jeffery Lacker spoke in Washington earlier today. Worth mentioning that he spoke a little about his rational for his dissent at the last two FOMC meetings.
On housing:
"Many macroeconomic analysts are concerned about the potential fallout of a weakening housing market. The direct impact of the housing market on overall economic activity is easy to calculate. The measure of residential investment spending that is included in real GDP has now fallen for three consecutive quarters. In the second quarter it fell at an annual rate of 11.1 percent, and appears likely to decline even more rapidly in the second half of this year. Since residential investment accounts for less than 6 percent of GDP, that lowered the real GDP growth rate by about seven-tenths of 1 percent in the second quarter. It would not be surprising to see housing reduce growth by even more for a few quarters. That would be a significant drag on the economy, but it would not end the expansion either, especially in light of offsetting strength in business investment spending..."
So if he has a more sanguine view of the housing market and its impact on economic growth, it makes sense that he'd reject the notion that upcoming weakness would allow inflation to decline. I think housing is a pretty big deal, as I've mentioned before. I think a significant decline in home prices could very well lead to a recession. My thinking on housing is that it will look more like several years of soft prices rather than a crash. Its the crash scenario which causes a recession.
Later, he hits the point more directly:
"Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability."
Again, nothing terribly new here, but its another FOMC voting member saying that they are unwilling to allow current inflation levels to become expected inflation levels. Basically he's saying he'd rather be safe than sorry on inflation, and he's not convinced that the weakness everyone sees is going to come to fruition.
Richmond Fed President Jeffery Lacker spoke in Washington earlier today. Worth mentioning that he spoke a little about his rational for his dissent at the last two FOMC meetings.
On housing:
"Many macroeconomic analysts are concerned about the potential fallout of a weakening housing market. The direct impact of the housing market on overall economic activity is easy to calculate. The measure of residential investment spending that is included in real GDP has now fallen for three consecutive quarters. In the second quarter it fell at an annual rate of 11.1 percent, and appears likely to decline even more rapidly in the second half of this year. Since residential investment accounts for less than 6 percent of GDP, that lowered the real GDP growth rate by about seven-tenths of 1 percent in the second quarter. It would not be surprising to see housing reduce growth by even more for a few quarters. That would be a significant drag on the economy, but it would not end the expansion either, especially in light of offsetting strength in business investment spending..."
So if he has a more sanguine view of the housing market and its impact on economic growth, it makes sense that he'd reject the notion that upcoming weakness would allow inflation to decline. I think housing is a pretty big deal, as I've mentioned before. I think a significant decline in home prices could very well lead to a recession. My thinking on housing is that it will look more like several years of soft prices rather than a crash. Its the crash scenario which causes a recession.
Later, he hits the point more directly:
"Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability."
Again, nothing terribly new here, but its another FOMC voting member saying that they are unwilling to allow current inflation levels to become expected inflation levels. Basically he's saying he'd rather be safe than sorry on inflation, and he's not convinced that the weakness everyone sees is going to come to fruition.
Conspiracy!
I'm a bit of a conspiracy theorist when it comes to the Fed. No, I don't think they create inflation to help out the rich or anything like that (which is a patently stupid idea anyway, inflation helps debtors not savers). What I mean is that I think every word Fed board members speak or write has a purpose, and that each member is loathe to say anything which would not serve the Fed's purposes. Generally I think the purposes are three:
1) Maintain the Fed's credibility as inflation fighters.
2) Communicate the likely path of Fed moves in the coming months, or if genuinely uncertain, communicate what sort of events might cause a cut and what sort of events might cause a hike.
3) Jawbone the bond/forex markets into moving in a direction which supports the Fed's monetary policy goals.
So maybe if you could get Janet Yellen a little drunk and ask her about monetary policy, she might dismiss the idea that core inflation around 2.8% is nothing to worry about, and its safe for us to start cutting rates now to prevent a housing market crash. But when she speaks publicly, she emphasizes that inflation is above the area where the Fed is comfortable, and then back tracks into reasons why the Fed will stay on hold. Read her speech from Monday. That's exactly what she does. Now, I have no idea what Janet Yellen really thinks about the economy. I haven't managed to get her drunk... yet. I don't know to what extent she's tempering her speeches to conform with official Fed views. All I'm saying is that I believe if she did think that a cut was appropriate now, she wouldn't say so.
So if I think Fed members do not really speak their minds in public, doesn't that make reading their speeches a waste of time. Quite the opposite, I say. If you believe that each speaker is trying to honestly communicate the direction the Fed is heading, regardless of the speakers personal opinion, then its as though each speech is really given by the whole Federal Reserve Board and not just one member.
Now, I'm sure the Fed governors who read my blog will object. So Moskow, don't bother e-mailing me. I'm not saying Ben Bernanke goes over each speech before its given. Or even that he gives talking points to board members. Rather I think they have agreed that transparency is best, and communicating vastly different messages would only confuse the market. On the other hand, having different people saying basically the same thing over and over again using different words, would serve to constantly reinforce the Fed's message. It also limits any misinterpretation of the Fed's intentions.
Don't confuse the relative conformity of the speeches with a lack of debate inside the FOMC. I think there is plenty of debate. I've heard a couple Fed staff economists either speaking privately or writing on a blog who have knowledge of how the meetings go down say that there is considerable debate. Both about the actual move and the statement. I believe that. I have to think that any economist who reaches the level of Fed board member has a fair sized ego, and isn't likely to just give in to whomever is chairman at the time.
Anyway, it is in this light that I wait to read the minutes. The trader in me says sentiment is pretty bearish right now, so a rally this afternoon is probably more likely than a selloff, but the fundamentalist in me says rates should be a bit higher, so the sentiment thing is not something I'd trade on anyway.
1) Maintain the Fed's credibility as inflation fighters.
2) Communicate the likely path of Fed moves in the coming months, or if genuinely uncertain, communicate what sort of events might cause a cut and what sort of events might cause a hike.
3) Jawbone the bond/forex markets into moving in a direction which supports the Fed's monetary policy goals.
So maybe if you could get Janet Yellen a little drunk and ask her about monetary policy, she might dismiss the idea that core inflation around 2.8% is nothing to worry about, and its safe for us to start cutting rates now to prevent a housing market crash. But when she speaks publicly, she emphasizes that inflation is above the area where the Fed is comfortable, and then back tracks into reasons why the Fed will stay on hold. Read her speech from Monday. That's exactly what she does. Now, I have no idea what Janet Yellen really thinks about the economy. I haven't managed to get her drunk... yet. I don't know to what extent she's tempering her speeches to conform with official Fed views. All I'm saying is that I believe if she did think that a cut was appropriate now, she wouldn't say so.
So if I think Fed members do not really speak their minds in public, doesn't that make reading their speeches a waste of time. Quite the opposite, I say. If you believe that each speaker is trying to honestly communicate the direction the Fed is heading, regardless of the speakers personal opinion, then its as though each speech is really given by the whole Federal Reserve Board and not just one member.
Now, I'm sure the Fed governors who read my blog will object. So Moskow, don't bother e-mailing me. I'm not saying Ben Bernanke goes over each speech before its given. Or even that he gives talking points to board members. Rather I think they have agreed that transparency is best, and communicating vastly different messages would only confuse the market. On the other hand, having different people saying basically the same thing over and over again using different words, would serve to constantly reinforce the Fed's message. It also limits any misinterpretation of the Fed's intentions.
Don't confuse the relative conformity of the speeches with a lack of debate inside the FOMC. I think there is plenty of debate. I've heard a couple Fed staff economists either speaking privately or writing on a blog who have knowledge of how the meetings go down say that there is considerable debate. Both about the actual move and the statement. I believe that. I have to think that any economist who reaches the level of Fed board member has a fair sized ego, and isn't likely to just give in to whomever is chairman at the time.
Anyway, it is in this light that I wait to read the minutes. The trader in me says sentiment is pretty bearish right now, so a rally this afternoon is probably more likely than a selloff, but the fundamentalist in me says rates should be a bit higher, so the sentiment thing is not something I'd trade on anyway.
Tuesday, October 10, 2006
What now?
I had been arguing that the Treasury market had rallied too far too fast for several weeks now. I can't say "I was right" quite yet, because at the time I wrote that, the 2 year was above 4.90%. We have, however, backed up about 20bps on 10's and nearly 25bps on 2's since Wednesday.
So at what point do I retract my "too far too fast" claim? I took another look at the Fed path analysis which I have done in the past. It looks like the median path is still for a rate cut around February 2007, and then two more over the next 18 months. Is that reasonable?
Well, reading all the Fed speeches over the last 3 weeks, I say not quite. The most reasonable scenario is for no more than 1-2 cuts over the next 12-months, with the first coming at least 6-months out. That makes your best case scenario with the 2 and 5-year about 5bps higher. If its only 1-cut, that implies a 25bps sell-off. If its no cuts, I think we sell off 40bps.
So I'd say the risk/reward starts to turn against a short position someplace around 2yr=5.00%, 5yr=5.05%, and 10yr=5.10%. Obviously new data could change my mind.
So at what point do I retract my "too far too fast" claim? I took another look at the Fed path analysis which I have done in the past. It looks like the median path is still for a rate cut around February 2007, and then two more over the next 18 months. Is that reasonable?
Well, reading all the Fed speeches over the last 3 weeks, I say not quite. The most reasonable scenario is for no more than 1-2 cuts over the next 12-months, with the first coming at least 6-months out. That makes your best case scenario with the 2 and 5-year about 5bps higher. If its only 1-cut, that implies a 25bps sell-off. If its no cuts, I think we sell off 40bps.
So I'd say the risk/reward starts to turn against a short position someplace around 2yr=5.00%, 5yr=5.05%, and 10yr=5.10%. Obviously new data could change my mind.
Jobs, Jobs, and more Jobs!
The market sold off hard on Friday and is following through today, in large part on news that the Department of Labor is revising their estimation of job creation from March 2005-March 2006 upward by 810,000.
Last week I said that I didn't think jobs was the key to what the Fed did next. I still think that, but I think this new revelation from Labor has caused many marketeers who did think jobs was a key to come over to my way of thinking. In fact, Yellen of the San Francisco Fed described the labor market as modestly tight. So aside from housing, it appears the set of arguments for a near-term cut are dissipating.
Last week I said that I didn't think jobs was the key to what the Fed did next. I still think that, but I think this new revelation from Labor has caused many marketeers who did think jobs was a key to come over to my way of thinking. In fact, Yellen of the San Francisco Fed described the labor market as modestly tight. So aside from housing, it appears the set of arguments for a near-term cut are dissipating.
If you're Yellen.... from San Francisco
Be sure to wear a flower in your hair...
Nothin'? Tough crowd.
Anyway, Janet Yellen of the San Francisco Fed spoke on her economic outlook yesterday. Hence the bad joke. Although not as hawkish as Plosser or Kohn from last week, but she doesn’t sound to keen on a rate cut in the near future.
"Why does a pause make sense to me now, while at the same time I say I'm worried that inflation is too high? My answer is that I do want to see inflation move down, but I believe policy may now be well-positioned to foster exactly such an outcome while also giving due consideration to the risks to economic activity. "
It seems as though the market is coming around to my view that while the next move by the Fed may be a cut, it may not be for some time, and may only be 1-2 cuts in total.
Nothin'? Tough crowd.
Anyway, Janet Yellen of the San Francisco Fed spoke on her economic outlook yesterday. Hence the bad joke. Although not as hawkish as Plosser or Kohn from last week, but she doesn’t sound to keen on a rate cut in the near future.
"Why does a pause make sense to me now, while at the same time I say I'm worried that inflation is too high? My answer is that I do want to see inflation move down, but I believe policy may now be well-positioned to foster exactly such an outcome while also giving due consideration to the risks to economic activity. "
It seems as though the market is coming around to my view that while the next move by the Fed may be a cut, it may not be for some time, and may only be 1-2 cuts in total.
Friday, October 06, 2006
Market takes weak NFP in stride
The bond market is actually slightly lower after non-farm payroll growth came out at a meager 51,000. Bloomberg had expected 120,000. There are a couple explanations, one is the previous figure was revised up to 188,000 from 128,000. The last two months job growth has been 239,000 vs. expectations of 248,000. Not much of a miss.
The other is that the unemployment rate fell. Who cares?
The third is that average hourly wages increased by 0.2% versus expectations of 0.3%. That leaves YoY hourly wages increasing at a 4% clip. That's the highest rate since 2001. Again, taking the current readings on inflation, wage growth, etc., I just don't see how the Fed cuts rates aggressively in 2007.
The other is that the unemployment rate fell. Who cares?
The third is that average hourly wages increased by 0.2% versus expectations of 0.3%. That leaves YoY hourly wages increasing at a 4% clip. That's the highest rate since 2001. Again, taking the current readings on inflation, wage growth, etc., I just don't see how the Fed cuts rates aggressively in 2007.
Thursday, October 05, 2006
Kohn and Plosser sink the bond market
Fed Vice Chair Donald Kohn spoke last night in New York on his economic outlook. His speech sounded a good bit more hawkish than Poole or Hoenig's recent speeches. I think the key quote for markets is the following:
"Even if my relatively favorable forecast comes true, the level of short-term interest rates that will produce this forecast remains uncertain. Obviously, as my FOMC voting record indicates, I believe that, for now, the current level of short-term rates has the best chance of fostering this outcome. Looking ahead, policy adjustments will depend on the implications of incoming data for the projected paths of economic activity and inflation. I must admit I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point, judging by the very low level of implied volatilities in the interest rate markets."
This came in his conclusion where he was talking explicitly about his view on monetary policy. So he seems to think that the next move by the Fed could be in either direction, and he is surprised to see the market trade so one-sided.
Philadelphia Fed President Charles Plosser also spoke today in Philadelphia. This speech seems to be focused on giving his general views on monetary policy, and is focused on the primacy of price stability. Plosser is new to the Fed, having come on in August. He sounds like a real hawk, but don't they all?
Anyway, anyone who thinks the Fed will cut just because GDP growth slows slightly should read this speech. Particularly quotes like this:
"The fact is that economists have had a very difficult time identifying any reliable and exploitable link between monetary policy actions and real output or employment in the short run either. Policymakers have neither the knowledge nor the tools to manage aggregate demand with the timing and precision necessary to neutralize the impact of unexpected shocks on output or employment."
Or this (emphasis is in the original):
"...if a negative productivity shock causes potential economic growth to slow, then market interest rates will tend to fall. So, again, as long as inflation is at an acceptable level, the Fed would want to reduce the federal funds rate as well, to facilitate this adjustment of output growth to a rate consistent with the new economic fundamentals and, maintain price stability. Failing to do so would again result in a misallocation of resources and possibly deflation."
So what's he saying? That cutting rates to stimulate growth isn't particularly effective. That rate cuts can only come at a time when to do otherwise might risk deflation. As to his opinion on the current situation?
"Assessing our current circumstance against my three principles of sound monetary policy, I find three things to be true. First, there is a significant possibility that inflation rates will remain above those consistent with price stability for some time. Second, this prolonged period of relatively high inflation runs the risk of undermining public confidence in our commitment to price stability, thereby raising the cost to the economy of restoring price stability. Third, sectoral adjustments not withstanding, the overall economy is likely to return to its potential growth rate in 2007."
Mmmmm... don't see any rate cuts anywhere in that paragraph.
Still think the Treasury market is ahead of itself. Today's sell off, 3/8 on 10's, just erases yesterday. It doesn't change the picture.
"Even if my relatively favorable forecast comes true, the level of short-term interest rates that will produce this forecast remains uncertain. Obviously, as my FOMC voting record indicates, I believe that, for now, the current level of short-term rates has the best chance of fostering this outcome. Looking ahead, policy adjustments will depend on the implications of incoming data for the projected paths of economic activity and inflation. I must admit I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point, judging by the very low level of implied volatilities in the interest rate markets."
This came in his conclusion where he was talking explicitly about his view on monetary policy. So he seems to think that the next move by the Fed could be in either direction, and he is surprised to see the market trade so one-sided.
Philadelphia Fed President Charles Plosser also spoke today in Philadelphia. This speech seems to be focused on giving his general views on monetary policy, and is focused on the primacy of price stability. Plosser is new to the Fed, having come on in August. He sounds like a real hawk, but don't they all?
Anyway, anyone who thinks the Fed will cut just because GDP growth slows slightly should read this speech. Particularly quotes like this:
"The fact is that economists have had a very difficult time identifying any reliable and exploitable link between monetary policy actions and real output or employment in the short run either. Policymakers have neither the knowledge nor the tools to manage aggregate demand with the timing and precision necessary to neutralize the impact of unexpected shocks on output or employment."
Or this (emphasis is in the original):
"...if a negative productivity shock causes potential economic growth to slow, then market interest rates will tend to fall. So, again, as long as inflation is at an acceptable level, the Fed would want to reduce the federal funds rate as well, to facilitate this adjustment of output growth to a rate consistent with the new economic fundamentals and, maintain price stability. Failing to do so would again result in a misallocation of resources and possibly deflation."
So what's he saying? That cutting rates to stimulate growth isn't particularly effective. That rate cuts can only come at a time when to do otherwise might risk deflation. As to his opinion on the current situation?
"Assessing our current circumstance against my three principles of sound monetary policy, I find three things to be true. First, there is a significant possibility that inflation rates will remain above those consistent with price stability for some time. Second, this prolonged period of relatively high inflation runs the risk of undermining public confidence in our commitment to price stability, thereby raising the cost to the economy of restoring price stability. Third, sectoral adjustments not withstanding, the overall economy is likely to return to its potential growth rate in 2007."
Mmmmm... don't see any rate cuts anywhere in that paragraph.
Still think the Treasury market is ahead of itself. Today's sell off, 3/8 on 10's, just erases yesterday. It doesn't change the picture.
Wednesday, October 04, 2006
ISM, Bernanke push Treasuries higher
The ISM Non-Manufacturing (read = service industry) came out weaker today, most notably in the prices-paid area, which declined from 72.4 to 56.7. I'm sure a lot of that is energy-related, but still, a massive decline.
Treasury market shot up about 3/8 on the news. It has held there after a Bernanke speech on savings. The speech is interesting in and of itself, but includes nothing on monetary policy or near-term economic issues. In the Q&A he did say that housing was in the midst of a "substantial correction," and would be a drag on economic growth. On the other hand, he said explicitly that inflation is current above "what we would consider price stability."
I think this is another example of the Fed building a case for a cut or two in 2007. I still am searching for the evidence that the Fed will be more aggressive than that, which would justify current bond market levels.
Treasury market shot up about 3/8 on the news. It has held there after a Bernanke speech on savings. The speech is interesting in and of itself, but includes nothing on monetary policy or near-term economic issues. In the Q&A he did say that housing was in the midst of a "substantial correction," and would be a drag on economic growth. On the other hand, he said explicitly that inflation is current above "what we would consider price stability."
I think this is another example of the Fed building a case for a cut or two in 2007. I still am searching for the evidence that the Fed will be more aggressive than that, which would justify current bond market levels.
Help Wanted: Ability to interpret the ADP survey a must
The ADP payroll survey was released this morning -- +78,000. The survey for Friday's non-farm payroll report is +120,000, so if the ADP survey were accurate (don't laugh), that would be a fair sized miss.
The market is up moderately -- 10yr +5 ticks. I think the ADP survey is worth paying attention to, despite its recent inaccuracies. However, I'm not sure whether +78,000 or +120,000 is the real key to what direction the Fed moves next. I'm paying attention to inflation figures first, consumer spending second, commercial activity third, and employment fourth. So if you put a gun to my head, I'd say whatever direction the market moves after the NFP number, I'd fade it.
The market is up moderately -- 10yr +5 ticks. I think the ADP survey is worth paying attention to, despite its recent inaccuracies. However, I'm not sure whether +78,000 or +120,000 is the real key to what direction the Fed moves next. I'm paying attention to inflation figures first, consumer spending second, commercial activity third, and employment fourth. So if you put a gun to my head, I'd say whatever direction the market moves after the NFP number, I'd fade it.
Hoenig hones in on inflation (I've got a million of these!)
Federal Reserve Bank of Kansas City president Thomas Hoenig gave a speech in Albuquerque last night, somehow able to put aside his woes over another pathetic season for the Kansas City Royals. Hoenig has been with the KC Fed in some fashion FOREVER. Before Greenspan, before Volcker, there was Hoenig. I wonder if he was pissed that he was never serious considered for the top job when Greenspan retired. Do you think he sits in FOMC meetings making those sort-of jealous, under-your-breath criticisms of Bernanke? Like he leans over to one of his staff economists and says "Volcker would never have used this color combination for the graph of GDP versus potential GDP. It just looks amateur."
OK, probably not.
Anyway, the speech isn't on the FRB of KC website yet, (who's amateur now Tommy?) but here are the highlights. He described the current monetary policy stance as "modestly restrictive. It's not tight, but modestly restrictive." He said that the Fed's "major challenge" is to bring core inflation down to around 2% (currently 2.8%). "Inflation, honestly, right now is too high." However, he goes on to say that the rate moves already made would take time to have an effect. So on the whole, it sounds like he's in favor of keeping rates about where they are until there is more evidence of a slowdown. Which is consistent with what I've been writing about for the last few weeks.
OK, probably not.
Anyway, the speech isn't on the FRB of KC website yet, (who's amateur now Tommy?) but here are the highlights. He described the current monetary policy stance as "modestly restrictive. It's not tight, but modestly restrictive." He said that the Fed's "major challenge" is to bring core inflation down to around 2% (currently 2.8%). "Inflation, honestly, right now is too high." However, he goes on to say that the rate moves already made would take time to have an effect. So on the whole, it sounds like he's in favor of keeping rates about where they are until there is more evidence of a slowdown. Which is consistent with what I've been writing about for the last few weeks.
Tuesday, October 03, 2006
Hedge funds as risk reducers
We all know how insurance companies work. They collect a premium from policy holders and in exchange agree to pay out a large sum whenever some predetermined event occurs. While the payout to any given policy holder may be well in excess of the premiums paid, the insurer collects premiums from many policy holders and as long as the correlation among payouts remains small, the insurance business remains profitable.
What happens if the correlation among payout events becomes high? For example, what if there was a homeowners insurer who only operated in Florida? As soon as a major hurricane swept through, the insurer would face a slew of claims, possibly driving them out of business. If the homeowners don't get paid on the insurance policies, they cannot rebuild, and suddenly the area hit by the hurricane is in a permanent economic depression.
In real life, insurance companies work hard to diversify various elements of their insurance portfolio. One means of doing this is through re-insurance. Today, many hedge funds are in the re-insurance game through so-called side-car investments. These investments allow insurance companies to off-load the risk of certain events occurring, and allow the hedge fund to reap returns in the 20-30% range should those events not come to fruition. The linked article from the WSJ talks about side-cars done to protect against hurricane damage, but one imagines these vehicles could be used for any type of risk.
The side-car is risky. If there were to be a large number of hurricanes, then the hedge funds would suffer steep losses. But let's think about who really wins when risk is spread out. If we have insurance companies better suited to pay claims in the event of a disaster, and if the risk of a disaster is spread among a wide range of investors rather than a single insurance company, the whole system is better off.
A lot of time is spent talking about how hedge funds may or may not be contributing to systemic risk. Here is a clear example of hedge funds reducing systemic risk.
What happens if the correlation among payout events becomes high? For example, what if there was a homeowners insurer who only operated in Florida? As soon as a major hurricane swept through, the insurer would face a slew of claims, possibly driving them out of business. If the homeowners don't get paid on the insurance policies, they cannot rebuild, and suddenly the area hit by the hurricane is in a permanent economic depression.
In real life, insurance companies work hard to diversify various elements of their insurance portfolio. One means of doing this is through re-insurance. Today, many hedge funds are in the re-insurance game through so-called side-car investments. These investments allow insurance companies to off-load the risk of certain events occurring, and allow the hedge fund to reap returns in the 20-30% range should those events not come to fruition. The linked article from the WSJ talks about side-cars done to protect against hurricane damage, but one imagines these vehicles could be used for any type of risk.
The side-car is risky. If there were to be a large number of hurricanes, then the hedge funds would suffer steep losses. But let's think about who really wins when risk is spread out. If we have insurance companies better suited to pay claims in the event of a disaster, and if the risk of a disaster is spread among a wide range of investors rather than a single insurance company, the whole system is better off.
A lot of time is spent talking about how hedge funds may or may not be contributing to systemic risk. Here is a clear example of hedge funds reducing systemic risk.
Monday, October 02, 2006
Poole-side
I know this speech was Friday, but I'm just now getting to it.
St. Louis Federal Reserve president William Poole gave a speech titled "Data Dependence" on Friday. There is something here for everyone. The following quote the key to the speech:
Once inflation and inflation expectations rise, the economy will become less stable and reducing inflation from an elevated rate will be more costly than taking the medicine now. Having said that, if inflation pressures are easing, even if only gradually, and there is a genuine prospect that inflation will return to the comfort zone, then I see no reason to accelerate the decline in inflation by maintaining a restrictive policy in the face of declining employment. Policy needs to be as disciplined as necessary to get the job done, but not more so.
I note that earlier in the speech, he described inflation as outside the Fed's comfort zone. So this emphasizes that the Fed is more concerned with keeping inflation expectations down, because once inflation takes hold, it can accelerate out of control. See the late 1970's. On the other hand, if it looks like the economy is weakening and inflation will naturally subside, there is no need to remain restrictive.
Combine that with this quote from the conclusion:
To say that policy is data dependent means that policy changes will depend on the incoming news about the state of the economy, both real growth and inflation. That the policy setting is data dependent is a good sign. It means that policy is in a range than can be considered neutral - that is, thought to be consistent with the Fed's longer-run policy objectives.
So if policy is neutral now, and it looks like inflation will subside slowly from current levels back toward the Fed's comfort zone because of weaker growth, how aggressively will they cut? Earlier, he said the Fed should not "maintain a restrictive policy," but didn't say anything about a neutral one. I think we can infer the Fed would be likely to cut, but the cutting would be less than were policy currently "restrictive." In the Q&A he said "Unless we get some large shocks, it is likely that policy adjustments will be relatively modest."
Reading this, it does seem as though Poole is starting to ready the market for cuts. But I also think he is cautioning that the Fed itrulyly data dependent, as his title suggests. The market is pricing aaggressiveve easing cycle, and this speech is certainly not suggesting any such thing.
St. Louis Federal Reserve president William Poole gave a speech titled "Data Dependence" on Friday. There is something here for everyone. The following quote the key to the speech:
Once inflation and inflation expectations rise, the economy will become less stable and reducing inflation from an elevated rate will be more costly than taking the medicine now. Having said that, if inflation pressures are easing, even if only gradually, and there is a genuine prospect that inflation will return to the comfort zone, then I see no reason to accelerate the decline in inflation by maintaining a restrictive policy in the face of declining employment. Policy needs to be as disciplined as necessary to get the job done, but not more so.
I note that earlier in the speech, he described inflation as outside the Fed's comfort zone. So this emphasizes that the Fed is more concerned with keeping inflation expectations down, because once inflation takes hold, it can accelerate out of control. See the late 1970's. On the other hand, if it looks like the economy is weakening and inflation will naturally subside, there is no need to remain restrictive.
Combine that with this quote from the conclusion:
To say that policy is data dependent means that policy changes will depend on the incoming news about the state of the economy, both real growth and inflation. That the policy setting is data dependent is a good sign. It means that policy is in a range than can be considered neutral - that is, thought to be consistent with the Fed's longer-run policy objectives.
So if policy is neutral now, and it looks like inflation will subside slowly from current levels back toward the Fed's comfort zone because of weaker growth, how aggressively will they cut? Earlier, he said the Fed should not "maintain a restrictive policy," but didn't say anything about a neutral one. I think we can infer the Fed would be likely to cut, but the cutting would be less than were policy currently "restrictive." In the Q&A he said "Unless we get some large shocks, it is likely that policy adjustments will be relatively modest."
Reading this, it does seem as though Poole is starting to ready the market for cuts. But I also think he is cautioning that the Fed itrulyly data dependent, as his title suggests. The market is pricing aaggressiveve easing cycle, and this speech is certainly not suggesting any such thing.
Capitulation ends early...
I thought the capitulation trade would last a little bit longer, pushing the 10-year through 4.50%. We've backed up 10bps since then. Since the capitulation was incomplete (in my opinion), the backup should short-circuit at some point, because those who wanted in before will be happy to get in at cheaper levels.
Where we go from there will depend on the data. I still think we need seriously negative economic data to sustain this rally. FF futures now look like a lock for a cut sometime between now and May. It will take more than that to prevent the 10-year from selling off.
Where we go from there will depend on the data. I still think we need seriously negative economic data to sustain this rally. FF futures now look like a lock for a cut sometime between now and May. It will take more than that to prevent the 10-year from selling off.