Is that all there is?

The lyrics from the 1969 song by Peggy Lee are very similar to the statement released yesterday by the FOMC after its two day meeting. “As I sat there watching the marvelous spectacle, I had the feeling that something was missing. I don’t know what, but when it was over, I said to myself, is that all there is to a circus? If that’s all there is my friends, then let’s keep dancing.” The Fed keeps dancing to its own strange tune and left the overnight funds rate at 2.00%. The statement released after the meeting created confusion about future Fed policy decisions. Uncertainty is the biggest enemy of markets and the U.S. stock market immediately fell sharply accompanied by a decline in the dollar. Two weeks ago Fed chief Bernanke told financial markets he was closely monitoring the dollar and rising inflation expectations which sent short-term rates soaring with fears of an imminent Fed rate hike. Yesterday’s Fed statement had a little bit for everyone with words about firming in household spending and expanding economic activity. But they were followed in the next sentence by “labor markets have softened and financial markets remain under considerable stress.” The last paragraph focused on rising inflation expectations even though he expects inflation to moderate later this year and next year. Confused? Of course, if this was former Fed head Greenspan speaking the markets would not care and chalk it up to his way of communicating with the world. But this is a new Fed and Mr. Bernanke has told us numerous times it will be a transparent Fed that clearly states its thoughts and actions ahead of time. Maybe Ben needs to use the Greenspan model as he is failing miserably at communicating Fed policy, unless he really is confused????? He was very late in realizing the severity of the mortgage and housing crises and has consistently been late in reacting to liquidity problems waiting until the markets forced him to act. There are many reasons the U.S. is facing its worst recession since the 1930’s but it is clear it will take a forward thinking Fed Chairman and decisive action for us to hit bottom and begin a slow upward grind in the next 3-5 years.

The Fed spoke about rising inflationary expectations but the interest rate market doesn’t agree as the inflation component of the 10-year U.S. treasury is showing a very steady rate of 2.53% over the next decade. With the 10-year (blue) at 4.05% the recent decline has come as a result of reduced expectations of economic growth (1.52% pink) while the inflation component (yellow) remains in a tight range. I would only be concerned if the inflation expectation number rose above the 2.72% level reached in 2005. The other important point is that June has seen many rate peaks in the last few years, 2007= June 12th, 2006 = June 28th, 2004 = June 14th. With loan growth about to take a dramatic dive due to tight credit underwriting by lenders and zero credit availability my theme of “you can’t lend what you don’t have” continues with the exception of the twins (Freddie and Fannie) with an unlimited bankroll.

The past three months have seen long-term rates rise significantly as expectations of a Fed tightening increase but it’s important to note the market is often wrong about predictions of future Fed actions. As you can see from this chart (blue = 10-year note, pink = Fed Funds rate) May 2007 was a textbook example of a market that was convinced the economy was fine, the mortgage mess was contained and the Fed was going to raise rates. Not only did the Fed NOT raise rates but they actually began lowering them soon thereafter as the interest rate market began to realize its expectations were based on a Fed and administration that were telling the world real estate problems were transitory. They were wrong and many market participants suffered greatly led by banks that bought into the Fed’s belief of containment. If you don’t remember this period please take a minute to review articles from the WSJ, Bloomberg, NY Times etc. to refresh your memory.

The direction of long term rates

Long-term interest rates have been moving in an almost perfect correlation to U.S. stocks and the recent decline has come as a result of the severe sell off in the past week led by the financials. With next weeks (July 3rd) jobs report the focus before the long holiday weekend stocks may have a tough time finding a solid bottom. Long rates will need every bit of this stock decline to continue their fall with the first line of defense at 3.92% and an outside chance at 3.75%. Unless we see a decline in the inflation component it will be difficult for long rates to fall much below 4.00%. Fed policy is on hold through the remainder of this year which should set up an outstanding opportunity for those wishing to bet on a steeper yield curve. After witnessing a ride up to the 200+ BP level earlier this year the 2yearr-10year spread fell back to the 120 level after Bernanke stocked fears of an increase in the Fed rate. As it becomes clear to traders the Fed is on hold, the yield curve should climb back up to the 200+ level later this year. The impact of the stimulus checks and high CPI numbers in the next few weeks may scare the inflation fighters into higher interest rate land but this will again be followed by a return to lower rates in the fall as the lack of credit (oxygen) becomes the dominant problem for the Fed and the election year Congress. It’s never good when legislators become involved in the credit and financial markets so a roller coaster ride of threats and bizarre legislation may be the main event in the fall.

Stay tuned, the final episode for this economic disaster have yet to be written.

The Fed is speaking loudly but is it carrying a twig?

One week from today the Federal Open Market Committee (FOMC) convenes for an important two-day meeting that concludes with an announcement at 11:17am on Wednesday, June 25th. It is highly unlikely the Fed will make a change in the overnight Fed Funds rate but a rising fear of inflation and some unusual rhetoric over the past few weeks have led market rates higher. Just a couple of months ago markets were discounting much lower Funds rates or at worst a Fed that was on hold for the remainder of this year but a continued rise in oil and other commodities has increased inflation fears. In the last 17 days the U.S. 10-year Treasury note increased 46 basis points but contrary to press reports inflation wasn’t the cause but the counter trend rally in the economy that I forecast would hit at the same time as the $100+ billion of stimulus checks. Last week the CPI (retail) inflation report showed a 4.1% increase for the past 12 months and this summer might rise to the 5-6% level but when we dissect long-term interest rates the markets are telling us inflation is NOT the problem. One could easily come to the conclusion that rising inflation expectations have caused the recent increase in rates and many Fed speakers have expressed this fear but over the past 17 trading days the inflation component of the 10-year Treasury has fallen three basis points to its current level of 2.53%. Long-term rates have risen due to an increase in the real rate of return as expectations of a stronger economy bounce from the low levels seen earlier this year. This is very similar to the experience we witnessed in 2007 when the 10-year rose to the 5.26% level primarily on the assumption of a stronger economy NOT higher inflation. Last year (see archives) I forecast a major top in rates for June with a dramatic fall the remainder of the year. According to my records which I have kept for the past 40 years long-term rates fall 75% of the time in the 2nd half of the year. 2007 clearly followed the trend but 2008 began by showing similarities to the 25% of the time rates rise in the 2nd half of the year. On January 22nd I sent my daily subscribers a special e-mail forecasting a rate rise for the remainder of the year and that prediction continues today.

The good news comes from the market’s expectation of inflation as I believe the ability of the U.S. economy to grow at trend rates (2.0%+) will be extremely difficult over the next couple of years. Much like the government spending in 2005 from the Katrina disaster we are seeing much of the recent stimulus money being spent by consumers on basic necessities (gasoline, etc.) and unless wages show a dramatic increase in the next 12 months it will be impossible for the economy to grow as consumer spending is sure to decline to levels not seen in over a decade. With unemployment rising and credit creation coming to standstill the Fed will soon be faced with a choice between helping the economy or fighting an inflation dragon that is making a temporary visit for this year only.

Ben must choose soon or markets will create an accident

1987 was a year former Fed Chairman Greenspan will never forget as his first major decision of raising short rates to defend the dollar helped cause the stock market crash in October. Rarely do we ever hear anyone except the Treasury Secretary speak about the U.S. currency but both President Bush and Fed head Ben have clearly told the world in the past couple of weeks that the current level of the dollar is a concern and may have led to a higher US inflation rate. Oil is traded primarily in dollars and a 90% rise in the past 18 months has contributed to stress for the US consumer as more of their earnings are spent on gasoline and less on other items. Oil has risen almost 100% in Japan and yet the Japanese inflation rate remains well anchored below 1%. The Bank of Japan would love to see inflation rise as high rates of monetary growth have NOT led to excess credit creation but have created a weak currency and the legendary “carry trade” which hedge funds have used to borrow cheap funds for investment in other trades (US stocks, oil, etc.) Mr. Bernanke must be very careful not to inform the world markets his intentions unless he plans on following through with action. Recent remarks are eerily similar to those from the German finance minister in 1987 that triggered Greenspan’s reaction to raise rates. A similar rise in the overnight funds rate by the Fed this summer would do very little to cap current inflationary pressures. Normally the Fed raises interest rates to curb loan demand and send a signal that the economy is growing at a pace that will stimulate inflation due to high levels of capacity utilization, low rates of unemployment and high wage growth. None of those signs are present today nor are they even close to the point of worry. Loan demand has been stronger than normal as borrowers take down unused lines of credit fearing that the lines will be closed soon. The unemployment rate rose .5% last month and will soon move above 6% and unit labor costs are increasing at less than 4% a year. Capacity Utilization rates have declined this year and the only thing keeping the U.S. economy from plunging has been the stimulus checks sent over the past few months. Most importantly the banks desperately need capital and shareholders are angry at the massive dilution they have suffered due to the numerous sales of new shares at lower and lower and lower prices. The Fed has one HUGE weapon to help stabilize bank balance sheets and that is through its usual way of allowing banks to borrow short at low rates and lend long at higher rates. The yield curve which measures the difference between short and long rates had been widening until Ben announced the FOMC is prepared to fight inflation with higher short-term rates. The bond market immediately went into panic mode and sent long rates soaring but hiked the real rate not the inflation rate. If the inflation part of the 10-year doesn’t rise above its 2.72 % rate reached in 2005 we will soon see the 10-year back at the 3.92% rate pierced to the upside on May 27th.

It’s time for the Fed to step up or shut up

Markets hate uncertainty and current stock and bond market action send a clear message that they are confused. Will the Fed raise rates? Does the Fed know more than the bond market shows with its inflation component? Is the economy rebounding as shown by the real rate of return in the 10-year? Is the Fed’s priority the dollar? Hopefully these answers will arrive soon with a consistent theme from all Fed players that the priority is the health of the U.S. economy. Anything short of that will result in a growth rate of 0% or less for the remainder of this year. The clock is ticking and Ben must take a chapter from Mr. Greenspan’s playbook and lead the troops out of this treacherous time in US economic history.

Can a rising dollar stop the inflation monster?

Much has changed in the past week including a dramatic shift in direction from the Fed. For the first time in many years the Fed, Treasury and President have begun to speak about a stronger dollar. With oil priced in dollars there is a consensus that the price of oil is being driven by recent dollar weakness and in some instances as a substitute currency or store of value. Oil’s rocket ship advance this year has begun to have an effect on driving patterns as consumers finally pull back with gas prices over $4 per gallon. But, unlike other commodities, we are not seeing an increase in supply due to a moratorium on new refineries in the US. Last week voters in Union County, South Dakota approved the rezoning of 3,300 acres north of Elk Point for the construction of a $10 billion refinery.  When completed this would be the first new U.S. refinery in almost 30 years but won’t be up and running for many years. Any reduction in oil prices must come from a drop in demand and that is exactly what we are seeing this month. The big problem is that the price of oil is not only determined by US demand but other countries increased consumption due to low subsidized prices. China’s daily consumption is growing as much because of low prices (under $3 a gallon) as from an increase in income levels.

Does Mr. Bernanke remember 1987?

Philosopher George Santayana told the world in 1905 that “those who cannot remember the past are condemned to repeat it.” Former Fed Chairman Greenspan’s need to raise short-term interest rates to stop the dollar’s decline in the summer of 1987 strongly contributed to the stock market crash in October of that year. Current Fed Chairman Bernanke’s speech last night to a Fed conference on inflation sent panic throughout U.S. money and bond markets as he strongly implied the worst of the mortgage and economic crises is over and the FOMC is ready to raise overnight rates to fight rising inflationary expectations. The questions that must be asked are: Would the Fed really raise the Fed Funds rate (currently 2.00%) when credit availability is almost non-existent in the US? Or is this just rhetoric following last week’s comments by ECB head Trichet that the world should expect higher short-term rates to combat rising European inflation? Does the level of short-term rates matter if banks can’t lend what they don’t have? We will have these answers soon but in the meantime how should a borrower, investor or lender react to the violent moves the last three days in both short and long-term rates?

Does Ben know something we don’t?

It has always been assumed Fed Chairmen have better information than anyone else but in today’s internet/blog environment I am not sure that is true anymore. Friday’s jobs number showed continued weakness but a rising unemployment rate sent stocks down almost 400 Dow points. (Or was it the $10+ rise in the price of oil?) Monday Bernanke tells us the economy is recovering and rates soar with expectations growing for a Funds rate increase in the fall. Today the California State Controller releases May sales tax collections that show a $124 million decrease from the most recent projection. It is hard to believe the Fed has elected to attack only one part of its dual mandate (economic growth and low inflation) at the expense of the other but markets are confused about the next move by the Fed and confusion always results in lower prices and higher interest rates. June has been a very tough month the last few years for rates as last year we saw a strong move higher in the 10-year to a peak of 5.26% on June 12th. In 2006 rates rose until June 28th when they peaked at 5.24%. 2004’s advance ended on June 14th at 4.89%. Last year Bernanke told us in May that the mortgage mess would be contained to sub-prime and that message sent rates soaring but a reversal began in July as markets realized his comments were more hope than reality. This year’s counter trend rally in rates and the economy has arrived but not to the extent that should push rates up this quickly and leveraged players will soon enter the short end of the yield curve and take advantage of wide spreads between the 2.00% borrowing rate and the near 3.00% rate on the current two-year Treasury.  This will have a stabilizing effect and help to widen the yield curve.

The next 60 days will show the way for the remainder of the year.

The dollar may stabilize against the Euro in the next few weeks as many players exit their positions afraid that recent comments will be backed up by currency intervention (not seen since 2001). Unless the Fed actually does increase overnight rates further dollar strength will be dependent upon weakening economic stats from Europe and the UK. The key levels are 1.945 in the British Pound and 1.535 in the Euro and a break below could see an acceleration of the dollar advance. CPI stats are released on Friday (6/13) with expectations of a sizeable advance (5%+) due to recent increases in the price of gasoline. US stocks have been almost perfectly correlated with the dollar/yen and its recent break to 107.4 should lead to a further advance in stocks but with rising short-term rate expectations it will be interesting to see if hedge funds are willing to risk a big bet on the previously successful “carry trade.” It’s a time where most players are resting awaiting better opportunities when Fed policy intentions become clearer. There is no need to always play as smart real estate investors showed us when they began to take the majority of their chips off the table in 2005-06. They may have missed the last 5% of the move but have plenty of $$ remaining that can be used for purchases when this bear market in prices ends in 2009-10.

Fed chief Bernanke has spoken but are the markets listening?

The past two days Fed head Ben spoke to the world about the US economy, Fed policy and surprisingly the dollar. I watch almost every Fed speech that is televised live and tape for later analysis and carefully peruse transcripts when released by the individual Fed banks. During the Greenspan era both stock, bond and currency markets would grind to a halt before every speech and then move violently when a word or phrase was used that was open to interpretation or discussion. Fed speak became a separate language and those that became fluid took advantage of traders that didn’t realize the Fed was signaling a change in policy. Like everything in life we only see the future from our past experiences so the world assumed Bernanke would operate using the same communication model as his predecessor Alan Greenspan. It has taken over two years but markets have come to realize that Ben is speaking a much easier to understand language with not many hidden themes and more importantly consistent messages that businesses and investors can use to plan their financial future. In a couple of years this will result in narrower risk spreads for Treasury securities as the uncertainty of future Fed policy will dissipate with investors realizing they are hearing clear messages from the Fed head. We are already headed in that direction as today’s speech was initially covered live by CNBC and Bloomberg but both cut away to market news half way into his remarks and this would have never occurred during the Greenspan era.

Tuesday – the state of the US economy

By satellite to an International Monetary Conference in Barcelona, Spain Mr. Bernanke stunned currency traders by mentioning the dollar (usually only done by the Treasury Secretary) and then acknowledging the Fed is “carefully monitoring developments in the foreign exchange markets.” Is the Fed considering intervention to support the dollar? I’m sure it has crossed Ben’s mind but probably not a serious thought at this point and won’t be unless the dollar shows accelerated depreciation in the next few months. With many foreign economies about to turn south the dollar should be well bid for the next 12 months. There has been much talk from experts about the Fed increasing overnight rates later this year. I place small odds on that possibility as Ben told us “credit conditions generally remain restrictive in areas related to residential or commercial real estate.” The Fed knows that a tightening of monetary policy is a clear signal that it feels credit conditions are too loose and that is not even close to current conditions.

The biggest fear seems to be coming from those who see a rise in inflation due to high oil and food prices. He addressed those concerns with “a rough stabilization of commodity prices, even in high levels, would result in a relatively rapid moderation of inflation, consistent with the projections of Fed for 2009 and 2010.” The key words in that sentence were stabilization and rapid. If commodity prices hold at current levels (or decline) we will see a sharp fall in inflation. I have closely watched markets, inflation and interest rates for over 40 years and find that inflation is much more a result of increasing wages than commodity prices.  This chart shows how closely the annual rate of change in the CPI (consumer price index) tracks unit labor costs which measure labor compensation relative to labor productivity.

Wednesday – The 1975 economy versus today

Stagflation is a word that was coined during a period of slow growth and increasing inflation in the 1970’s. At Harvard Ben told graduating students that “you can only try to be as prepared as possible for the opportunities, as well as the disappointments, that will come your way. For people, as for economies, adaptability and flexibility count for a great deal.” He could have been easily speaking about the Fed’s current policies as he has had to be flexible (Bear Stearns) and adaptable (Lending facility) in the last six months. Many believe the Fed knows far in advance what will take place in the US economy and therefore how it will react through interest rate changes. This couldn’t be further from reality as Fed staff economists give detailed forecasts to the Fed head and his FOMC members but if we look back over the past couple of years we can clearly see many instances where the Fed was caught looking one way while the mortgage storm, etc. was coming from the opposite direction. In his speech to the Harvard students he reminded everyone that the forecasting record of economists is legendary (bad).

Where are we today? Where are we going?

The markets seem very much at peace with current Fed policy and the overnight Fed Funds rate at 2.00%. I would be very surprised if we saw any increase in short-term rates this year as the credit contraction shows no sign of ending. The Fed has made it clear that liquidity (the ability to borrow) is more important today than the actual interest rate to borrow. This will eventually change although Vice Chairman Kohn suggested making the extra lending facilities permanent. My theme for 2008 has been that banks can’t lend what they don’t have….long-term interest rates will continue to trend irregularly higher but see sharp down swings as leveraged buyers seize the opportunity to earn close to 4% on a 10-year while borrowing at 2% or under. The best investment opportunity lies in a bet on a widening yield curve in the US and England. The pound could easily fall under 1.90 before the end of the year forcing the Bank of England to ease overnight rates from their current 5.00% level. For stock market investors the Japanese yen continues to lead the way and as long as it remains above 102.50 (currently 105.28) the trend remains higher led by the Nasdaq and Transport sector.