Saturday, July 01, 2006

>What the Fed Really Said

Thursday saw a powerful response by the markets in stocks, bonds, commodities, and currencies to the communiqué from the Fed after its recent two-day meetings. Clearly, some were interpreting the communiqué to mean that the Fed had finally come to an end of its interest-rate-hiking ways. The immediate spin was quite "dovish" in terms of future rate hikes and concern about inflation.

That has become a pattern in the last year. The Fed releases its minutes, the immediate spin is that we are ready for a "pause," and the market rallies. Then we start to listen to the speeches from Bernanke and various Fed governors and are shocked - shocked, I tell you - that nothing has really changed and they intend to keep on raising rates in a measured manner.

But is yesterday something different? Can we see a glimmer of hope that the Fed is ready to pause? Is that the way to interpret the mere three paragraphs of content? As a surprise to no one, I take a contrarian view, just as I did with the May release. So, this week we parse the Fed release, take a look at the yield curve, and glance over our shoulder at Japan. Maybe it will give us a clue as to whether this week was a sucker's rally or the beginning of a bull run.

What the Fed Really Said
There are typically five paragraphs in each statement. The first and last rarely change, except to announce the interest-rate change. The short middle three paragraphs provide the real substance. Let's take a look at the actual three paragraphs. The changes from the May statement are in bold.

"Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

"Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.

"Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives."

In January the Fed removed the word "measured" from the statement and everyone interpreted that as dovish. We have since had four rate increases. In March, the initial response was that a pause was imminent, as again the markets read what they wanted to read into the statement. Last May, we again saw veteran Fed watchers seeing a statement which led them to think the Fed would pause.

(For clarification, "dovish" means that one believes inflation is not going to be a problem and therefore rates will not have to rise, and hawkish describes the view that inflation is a potential problem and rates will need to rise.)

At the beginning of the rate-increase cycle, the clear historical pattern for the Fed is to raise rates higher and longer than anyone then thinks. And it looks like this time is no exception.

Where does the dovish interpretation come from? The first sentence of the second paragraph, where they acknowledge that economic growth is moderating. After that, the statement reads rather hawkish to me.

The inclusion of the new sentence is key for me: "However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures."

Let's emphasize the word "sustain." They are clearly acknowledging what we have heard in speech after speech from Fed governors: inflation is now at an uncomfortable level. "Elevated" is the term they use in the statement. And yes, over time a slowing economy may indeed moderate those inflation pressures, as they point out, but over time is probably not going to happen in the next 15 days.

And 15 days is when we will see the next inflation figures for June. Has anybody noticed prices going down this month? Moderating? I don't see many hands going up. It is likely that we will get another "elevated" inflation number that will make the central banking gene in the voting members of the Fed governor create a lot of late night stomach acid.

We will get one other number before the August 8 Fed meeting, and that is the GDP number for the second quarter. The first-quarter number revision came out today, and it was revised up to 5.6%. That is rip roaring, almost Asian tiger-like growth. It is highly likely that GDP will come in stronger than 3% for the second quarter, giving the Fed clear space to raise rates one again in August.

Now, one can read the statement to make a case for a pause in September. There will be two more inflation numbers before the September meeting. If the economy is slowing down and inflation is coming down, both of which are possible, then the Fed may indeed pause. But let's think about that.

A slowing economy is not going to be good for profits, and thus not good for the stock market. But if the economy continues to rip and roar along with inflation at an elevated level, then the Fed is going to continue to raise rates. There are now some maverick calls that the Fed rate will be at 6% by the end of the year. If you are bullish on the economy, then that is a perfectly rational expectation.

But if rates continue to increase, then that is ultimately not going to be good for mortgage rates and the housing market. That will also impact consumer spending. That outcome is not good for the stock market either.

End of the Quarter Games

The market was already up 120 points when the Fed made its announcement and then roared ahead almost another 100 points. So it was not all Bernanke. In fact, I tend to think it was more likely end of the quarter gamesmanship, with funds working to move their favorite stocks up, moving into stocks that will look good in their portfolios and dumping the dogs. If XYZ stock is up 10% for the quarter, you want some of it in your portfolio to show investors you were on top of it. Of course, you don't have to say you got to the game late.

End of the quarter rallies are common. Any old excuse will do. My bet is that whatever the Fed did would have produced a rally, short of stating that they had decided a recession was in order.

But nothing fundamentally changed with the Fed rate increase. Thirty-year mortgages are now around 6.6%, which is a good 150 basis points higher than a few years ago. ARM rates are approaching 7% on an annual percentage basis, which is far higher than the 2% available a few years ago. As these rates re-reset, mortgage payments are going to go up considerably. Some new homeowners who loaded up on ARMs two years ago are simply not going to be able to handle an extra $2-4-600 a month increase without severely changing the rest of their spending habits.

I think it is highly likely the Fed will keep raising rates until we get either a slowdown or a recession. The irony is that the quicker the slowdown comes into view, the less severe it is likely to be. Why?

If the economy starts to weaken in the third quarter, with inflation coming back down, the Fed will stop raising rates. Given where we are today, it is likely we get a simple mid-cycle slowdown, just like we did in the mid-'80s and mid-'90s, and then the growth cycle continues.

But if the economy stays strong and inflation pressures do not abate, the Fed will raise rates higher and higher, which will ultimately put more pressure on the housing market and consumer spending. The risk is they go a raise (or three) too far and the economy falls rather swiftly into a real slowdown and/or a recession.

So, later in the summer, we are likely to be in the perverse situation where good news is bad for the markets and bad news is merely less bad.

Blame it on the Japanese

This afternoon I had a conversation with bond maven Jim Bianco. I called him to ask a question that has been perplexing me. Why haven't 90-day rates moved up with the Fed funds? Fed funds are at 5.25%. The 3-month T-bill is at 4.98%. The rest of the yield curve is acting normal for an inverted yield curve, but the current 3-month action is strange from a historical perspective. If you can get 5.24% for a 6-month bill, then you should take the 6-month over the 3-month.

As it turns out, there is no good reason for the anomaly, or at least not one that he knows of. And if anyone should know, it would be Jim. He thinks the likely explanation is that there is so much "flight to quality" that it is simply depressing the 3-month yield, as people who are looking for safety are not overly worried about yield. That makes some sense, but it is playing games with the yield curve.

The 6-month is now at 5.24% and the 10-year is at 5.14%, which is clearly an inversion. If you assume that the 3-month should be in line with Fed funds or 3-month LIBOR, that would mean a full yield-curve inversion across the curve. If that situation maintains itself, it suggests that we might see a serious slowdown or a recession in the late second quarter or in the third quarter of 2007 - if the normal "lag" between the yield curve staying inverted for 90 days and a recession showing up later is the same as it has been in the past.

In my conversation with Bianco, we discussed the Japanese taking the liquidity out of the market as a reason for the recent market correction. The Japanese money supply went from over 300 trillion yen down to 100 trillion yen in less than two months. But interestingly, the Japanese have increased their money supply by 50% in the last few weeks, back to 153 trillion yen, resupplying the world with a measure of liquidity. Evidently, either they or someone decided they went too far, too fast. Ultimately, they will mop up the excess liquidity, but hopefully at a more "measured" pace, giving the markets more time to adjust.

And as we close, this note from Gary Shilling is a good way to wrap things up.

"Central banks hyped the money supply early in the decade in reaction to stock meltdowns, 9/11 and deflation fears. But that money largely spurred asset speculation, not economic growth. Now they worry about asset inflation spreading to goods and services price hikes. So they're all constricting credit in lock-step fashion. In dollar terms, combined 9 central bank money supplies grew at a 7.9% annual rate from January 2001 through April 2006. Reducing that to 5%, in line with economic targets, would slash the combined money supply by 13%, the equivalent of a 10.9% cut in total GDP."

There are any number of headwinds to the economy, as Shilling and others (including your humble analyst) have noted. Among these:

1. High energy prices serve as a tax
2. Central banks everywhere tightening
3. A slowing housing market
Sooner or later, I think they will take their toll. The growth in consumer spending in recent years has been driven by rising home prices and the ability of US consumers to have access to cash-out financing. Higher mortgage rates are going to limit the growth in home prices and the ability of consumers to borrow, as well as drain more cash from disposable income. With wages barely rising in line with inflation, and not keeping up with the inflation of daily living, I think the potential for a consumer-led slowdown or recession is significant if the Fed keeps raising rates beyond August, and maybe/probably even if they do pause in September. That will not be good for the markets.

As my friend Matt Blackman noted recently, the trend is for the market to bottom in the third year of the presidential cycle. That would all fit if there is a recession and the inevitable recovery in 2007. I continue to suggest that readers look at absolute-return types of investments and be very careful of long-only stock market investments. The time will come when it will be safe to get back in the water. But in my opinion, that is not today.

John Mauldin emails.

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