Delayed Reaction

So the Fed accidentally forgot to mention that longer-term inflation expectations remain well contained (original here, new here). That revision appears to be responsible for the jump in TLT and QQQQ into the close. It also weakened the dollar a bit.

Housing stocks could end up the big winner as they didn't like the original statement while the mining stocks anticipated the dollar weakness pretty well. The mining stocks have been sold off hard lately so the rally might not have had much to do with the news.

I thought the original statement fit my morning thesis alright but the new one obviously fits better.

I imagine the statement change will make for a lot of chatter tomorrow. To me the two statements have the same meaning but I guess that is because I see the growth slowdown (lower oil, copper, and steel prices) relieving inflation pressures. I almost went on a rampage this AM about the silliness the Fed locks itself into trying to use language to convey future probabilities to the markets. Given the concerns they have about guiding the market it would be a lot easier just to publish a table of future rate moves and expected probabilities.

Fed Day

Mark Thoma put up a very interesting piece on what to expect out of the FOMC meeting a few days back. The gist was that the Fed will error towards tight money until Greenspan leaves to insure that inflation expectations remain low for his successor. That makes a lot of sense but it won't be much fun politically. It also talks a bit about the word "measured" and whether it stays or goes. My feeling on this is that last meeting's statement kept "measured" but led the market to foresee a 50 bp hike, making the word irrelevant.

The meeting minutes strengthened this view as the committee members dedicated a large amount of time to worrying that "measured" was being misinterpreted. The markets had been very clear that "measured" meant 25 bps at the next meeting but with the internal debate demonstrating unhappiness with such consensus the market will be more than happy to think something else or ignore the term altogether. More than a debate over the language the minutes indicated the committee is having a tougher time seeing 1-2 meetings ahead. I think it also indicated a widening spread of opinion about the balance of risks.

I would guess the statement today reflects more balance than the last one did and probably continued policy uncertainty. I would be surprised if they don't mention increased signs of weakness internationally and relief from commodity prices. Those statements will be weighed against the stronger inflation data and continued strength in housing. The data seems to have shifted away from growth and inflation since the last meeting. Anyway it will be 25 bps now and 25 bps expected for June but I bet more people begin looking for a pause thereafter.

That may be good news for domestic markets but I don't think dollar bulls will love it. I would guess we get more weakness against Asian currencies.

Another Interesting Fed Critique

From the FT ($$):

As early as the late 1990s, Federal Reserve officials from Alan Greenspan, the chairman, down have warned that the US external deficit is unsustainable. The Fed should be applauded for its analysis of the issues. But too many Fed officials are cheerleaders for the view that adjustment will be smooth.Even if one is confident that this will be the case, it is another matter to assert that a correction of the US external deficit will probably be benign in its effects on financial markets.

The Federal Reserve has been disingenuous in not stating that adjustment will require that the growth of total domestic demand - principally consumption and investment - slows dramatically. Assume that the US current account deficit will be halved over the next three to five years from its current 6 per cent of gross domestic product to 3 per cent. To accomplish this, the growth of demand - 4.4 per cent over the past year, and three-quarters of a percentage point faster than the 3.6 per cent growth of domestic output (GDP) - will have to be reduced by about 2 percentage points to three-quarters of a percentage point below the trend growth of potential output, which is about 3.2 per cent. In other words, to about 2.5 per cent or less.

This slowdown translates to $1,350 for every woman, man and child in the US. And the inevitable adjustment of dollar exchange rates, in the order of 30 per cent on average, will add an extra $1,000 per capita due to the adverse effects on the US terms of trade. The average price of US imports will rise relative to the average price of exports. No wonder politicians are staying away from this issue. The Federal Reserve does not have that excuse.

I don't think the Federal Reserve is going to take it upon themselves to half the current account deficit in 3-5 years but the foreign exchange market might.

Judging Fed Policy

David Altig (in four parts - I, II, III, IV) does a fair job at taking apart Stephen Roach's most recent Fed critique. I am using the word critique pretty liberally as Roach titles the piece "Original Sin" and claims the Fed is making him into a conspiracy believer. My view is that Roach goes wrong in laying his own problems with consumer and market responses at the Fed's doorstep.

The problem with an activist central bank is that decision makers in the real economy -- consumers and businesspeople alike -- mistake the Fed's point of view for strategic advice. And so do financial market participants.

It is hard to be active in the markets during recent years and not be a bit bewildered about what participants are thinking. It often feels like the markets are only looking ahead a few weeks to a few months and are completely unconcerned about what current price levels mean over a longer horizon. I look at GM, FNM, or AIG and wonder how the prices at year end could have ignored all the negative news that came out during the fall. Throw in a housing boom and record low credit spreads and I generally feel Roach's frustration that the world is taking a much too optimistic view. He just goes a bit overboard in laying the blame on monetary policy and Fed commentary.

While Altig clearly wins the point by point debate he sets out I still have some sympathy for Roach's view that the Fed is basically trying to extract itself from past mistakes. Altig ends his piece with the following challenge for believers like me:

-- I gather the prescription favored by those who feel the same as Stephen Roach is for the Fed to be more aggressive in tightening policy. Fine, but is that what you really would have done in 1997, confronted with the circumstances at the time? In 1998? Would you have been impervious to the global financial stress I noted in the second post?
-- Would you choose to ignore the fact that employment growth in the U.S. has consistently struggled to gain traction? Would you be confident enough that bubbles exist, and that monetary policy can do something about them if they do, to tighten monetary policy if you had some concerns about the underlying strength of the real economy?

I don't really have problem with Fed policy until around Nov 1998 and I think these issues are best addressed by Paul McCulley's more constructive Fed criticism from March of 2000:

Thus, it is just not credible for Mr. Greenspan to maintain that the wealth effect is not that closely linked to the stock market, when by his own analysis of a year ago, the New Economy stocks are running on a lottery principle. If his analysis of a year ago is still correct, and I certainly think it is, and if New Economy stocks have soared versus stagnant Old Economy stocks over the last year, which is a fact, then logic compels the conclusion that the excessive boost to aggregate demand that Mr. Greenspan abhors is related to the bubble in New Economy stocks.
Which brings us to the question of whether the interest rate tool is the right exclusive instrument for dealing with the problem. I know of no economic model that postulates a high interest elasticity of demand for lotteries! Virtually every economic model incorporates, however, a high interest elasticity of demand for the goods and services of the Old Economy.
Thus, using the interest rate tool exclusively to thwart wealth creation in New Economy stocks carries grave risks for the Old Economy. It makes no sense to try to get the attention of gluttons by starving anorexics. It's bad macroeconomic policy, and it is also morally wrong.
This is particularly the case in the face of evidence that the bubble in New Economy stocks is being increasingly fueled by margin debt, as vividly displayed in the graph below. While it is a free country, and everybody has a right to foolishly overpay for lottery tickets, I do not believe that the Fed should passively endorse the purchase of lottery tickets on credit!

Under Regulation T, the Fed has the authority to set initial margin requirements for the purchase of stocks on credit, which has been at 50% since 1974. The Fed should raise that minimum, and raise it now. Mr. Greenspan says "no," of course, because (1) he cannot find evidence of a relationship between changes in margin requirements and changes in the level of the stock market, and (2) because an increase in margin requirements would discriminate against small investors, whose only source of stock market credit is their margin account. I have rejoinders to both of those objections.

I liked this passage because it draws a direct connection between Fed policy and the distortion between new and old economy assets that occurred in 1999-2000. With the collapse of the stock market the opportunity to correct that misalignment without a liquidity injection passed and the Fed has not had much choice since then but to keep rates accommodative in the face of weak employment.

Pointing out past policy mistakes might seem a bit useless but I think it is the backdrop that makes the current fiscal policies such a problem. Our economy has grown by leveraging making it more dependent on the stability provided by counter-cyclical monetary policy. While that has gone on the legislative and executive branches of government are doing their best to restrict future monetary policy by borrowing in a heavily pro-cyclical fashion (similar to Calculated Risk's conclusion).

None of this really explains willingness of the market to act as a co-conspirator preventing poor policy decisions from being reflected in asset markets. My personal guess is that executive compensation is just not very closely tied to long-term performance. That being the case anyone able to draw liquidity out of the system now can benefit from whatever future volatility may arrive. This is wandering off the subject a bit but it doesn't seem fair to ignore the obvious market flaws necessary for any monetary and fiscal mistakes to have a lasting impact.

While defending Roach's piece is a bit difficult, I am not that comfortable absolving the Fed either.

CPI and Chinese GDP are Lagging Indicators

Lots of comments on the CPI setting a 5 month record yesterday but my thoughts are that it is a lagging indicator. Last week Wednesday the markets decided the growth phase was over. I would attribute it to the unrest in China the weakness in the copper and steel sectors. Not sure to what extent one led to the other but they certainly got a reaction in the Nikkei and global markets, eventually even causing interest rate markets to consider an end to Fed hikes. Oil is well off recent highs (some see that market as a double top) which fits nicely with a view that Asian growth has already peaked. The deterioration of U.S. export growth also added some fuel for those that wanted to see an international slowdown underway.

Long story short the world changed last week and if that change is correct the CPI, record or not, is meaningless. It is a lagging indicator plain and simple.

Chinese GDP which also came in stronger than expect has the same problem. Demand in the commodity sector is a much better indicator of what future expectations are for Chinese growth.

Bond yields peaked yesterday around 8:45 AM and I am guessing it is the "lagging indicator" logic that caused it. The beige book came in weak but that was much later in the day, after the market had made up its mind.

On these data points I am not expecting any impact beyond what we saw immediately after the release. I disagree 100% with the view that these inflation number force the Fed's hand and need to be reflected by higher bond yields. Even if I did see the CPI (or Chinese GDP) as a reason to adjust growth expectations, I would prefer to go long copper or oil futures. For bonds to run into trouble here I think we need to see the dollar slip further.

I will try to put up several posts today to round out my views on where the economy is going and my interpretation of recent market moves.

Stocks get Whacked on Bond Selloff

Didn't really see that coming. It is hard for me to understand the weakness in stocks given the FOMC statement. Since they hit my "bullish" case (along with expectations), I hate to think what would have happened had they not.

My feeling is that bonds got caught very wrong footed following this AM's PPI. The sharp reversal easily broke new lows in 5s and 10s which left them little chance to recover. Stocks in all sectors got sold , being led lower by Citibank (C) and AIG (AIG). I still think there is a chance for an equity rally tomorrow but am generally surprised at the way the stock market fell apart today.

I am particularly surprised that gold, silver, and copper stocks all came off with the market. I realize the dollar rallied but there is a disconnect between inflation fears and commodity weakness.

Inflation Targets and Asset Bubbles

From the Economist:

Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.

The author then gets a bit caustic with the Fed for reluctance to consider the overall liquidity picture and concludes with this.

During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.

While centering on the need to include asset prices in inflation measures the article falls a bit short by suggesting central banks should consider asset prices in their policy decisions. A better solution is to remove asset prices from central bank control. Robert Shiller discusses the Chilean UF (unit of development) in his book The New Financial Order (Amazon) as an example of an alternative system to limit central bank influence over asset prices. The UF is an inflation indexed unit of account which is repriced daily such that everyone knows the correct price of a UF in Pesos. The UF was created in 1967 and has become widely used for pricing long-term contracts such as housing prices and mortgages while pesos are still used for day-to-day purchases and salaries.

I am getting a bit out of my area of expertise but I am pretty sure the Fed (and probably the world) is running into the problem the Economist describes with asset prices demonstrating large value swings while goods prices remain stable. These swings are making it impossible to effectively manage liquidity in the system. Rather than giving central banks the difficult task of adjust policy to correct asset prices I think it is better to create a mechanism for asset price stability outside of central bank control.

Morning Already?

I recommend reading Nouriel Roubini's article on the housing bubble. He addresses the arguments on both sides of the issue and ultimately views the presence or absence of a bubble as a matter of faith. My faith says it is not the best time to be buying houses.

He also has a good summary of how the world economy got us to where we are.

So, the missed chance by the Fed to tighten early on to prevent the stock market bubble (and its further Fed Funds easing in 1998) was an important factor in allowing the bubble go on and eventually burst. Then, the bursting in early 2000 - only partly driven by the 175bps reversal btw mid 1999 and mid 2000 - was the main factor behind the 2001 recession (dot.com and Nasdaq crash leading to a real investment crash after the real investment bubble that had been itself fed by easy liquidity for too long). And the attempt to avoid the real consequences of the dot.com (and of all stock markets) crash then triggered another massive Fed easing - from 6.5% to 1% - that created the great bubble of 2003-2004 with all risky assets - equities, emerging market debt, housing, high yield corporates, commodities and even long-treasuries - surging in value and becoming overvalued and feeding even further the US households' leverage build-up and savings contraction. So, as Ken Rogoff once put it, massive Fed easing (6.5% to 1%), massive and reckless fiscal easing (from 2.5% of GDP surplus to 4% deficit) and sharp dollar fall (15% trade weighted so far and still going) gave us the best recovery that money can buy; but it also gave us the most drugged and artificial recovery that money can but leaving the US imbalances worse than before: twin deficit, short-term financing of these deficits with increasing rollover risk, sloshing liquidity, housing and risky assets bubbles, low savings and high leverage in households and among highly-leveraged agents, carry-trades and chasing for yield.

This summary in my mind is what explains why the Fed seems worried about inflation while the bond market remains calm. The Fed is not seeing a current problem so much as seeing an abundance of liquidity being provided through the corporate bond market. Today's CPI number while reassuring bond investors (and maybe stock investors), will not really relieve the current worries at the Federal reserve.

None of this really matters today. For, today I think JPM picked the wrong day to miss earnings.

Beware the flattening

The U.S. yield curve is definitely trending flatter here. One month ago 5-yr rates were at 3.31% and 30-yr rates were at 4.85%. Now they are at 3.56% and 4.91%, respectively. A 19 basis point (bp) flattening. Most of the shift came on the day of the FOMC meeting and the rest is happening this morning. The markets are changing their expectations for the Fed Fund's rate while keeping their long-term expectations for both the economy and interest rates relatively fixed.

Yesterday Fed Gov. Olson Spoke and the most striking part of his speech to me was the comments he made on real interest rates. After noting that the overnight rate remains accommodative he went on to say, "The nominal federal funds rate is currently 2 percent, a level that, using standard measures of core consumer price inflation, implies a real funds rate that is just above zero--considerably lower than the long-run average of about 2-3/4 percent." Nobody is expecting a Fed Funds rate of 3.75% anytime soon, not the Fed and certainly not the markets but that is the rate his comment implies. I was surprised his remarks did not have more of an impact on bonds yesterday and we may end up with a when-are-they-going-to-stop-hiking-panic in the short-end eventually. Not even close yet but the short-end is definitely reacting.

Even without a panic I think the treasury market will at some point steepen back out as people begin to find a 4% 5-yr rate attractive. Could take a while to play out as the market's belief in a low overnight rate is based in the belief in a weak economy. These Fed comments should be telling markets that they don't perceive the same need for stimulation.

This last point is also the only way to reconcile the strength in stocks with a curve flattening. Flattening is a sign of slowing growth and by keeping the long end low the bond market is not showing the same respect for the economy's strength (or even fear of inflation / stagflation) that the equity market is. In March of '03 the bond market was proven wrong and I think they will be here as well. I have absolutely no doubt that the Fed will avoid deflation and I have a growing faith in the U.S.' ability to export its way back to balance.

Until the Fed starts to give signals that rates are no longer accommodative I think it makes sense to be short bonds. The flattening is making me see the long end as vulnerable to a sharp move higher (yields) like the moves in the Spring of both '03 and '04.

position in TLT options.

Ostrich

A lot of people believe the Fed is out of touch with the economy, too optimistic, or political but these comments from Fed Governor Gramlich seem pretty well on the spot.

Watching the markets here the rally that began in August looks like the participation phase of a longer term move that began in Mar '03. I don't think the August move took many traders by surprise and the retail participation is a force to be reckoned with. I also continue to think that strong IPO's by publicly recognized brand names will continue adding fuel to the retail psychology.

A big wild card here is U.S. interest rates. I am surprised the Fed did not signal an end to its hiking cycle. They could have done it simply saying they were going to let their past hikes work or by claiming inflation risks have ebbed. I believe that the Fed usually has better information than the markets and that their comments lead the news by about a month. We are at a delicate point here where oil rates are near there highs and have now worked off an overbought condition. Higher oil is just the tip of the iceberg as we are also approaching a point where it will become clear whether commodity price increases can be isolated or will lead to cost push inflation. The pop in bonds at the end of the week may continue for a couple of days but ultimately will be a good point to get short.

Fed Impact

I read the FOMC statement as saying we will get another 25 bp hike in December which is what the market has been anticipating since last Friday. This should be bullish for the dollar simply because its carry against other currencies has improved on margin since last week Thursday.

I would call it bullish for the long end of the treasury curve too as the Fed seems to be taking proper precautions against inflation.

All in all the report was what the market was expecting so the net effect should simply lend more confidence to the markets.

Fed Day! Fed Day!

Excerpts from the Dow Jones news wire:

Most forecasters believe the Fed will update its language to indicate that
in the wake of the very strong October jobs data, the employment sector has
improved. At the September policy meeting, the Fed said "labor market conditions
have improved modestly," and observers believe that now, that final word will be
chopped. Meanwhile, while the Fed said in September that "output growth appears
to have regained some traction," analysts also believe things have improved
enough to speak of that growth in more enduring terms.

In August, the FOMC blamed the unexpected slowing in growth on rising
energy prices. Fed officials said repeatedly that they expected the rise in
energy to be transitory, and while their timetable was a bit off, oil prices
have been moderating of late. In September, the Fed again noted a "rise" in
energy prices, which Matus now believes will be reidentified as a "past surge."


Where there's a bit less clarity, it's on how the Fed will approach its
inflation views. Few forecasters think the central bank's so-called balance of
risks statement will be changed. But there's fairly broad-based support for a
move that would see the Fed note some modest level of concern about price
pressures, especially in the wake of the consumer price index for September,
which showed an unexpectedly strong gain.

Perhaps the part of the Fed's policy statement that gets the most attention
is the third paragraph of what's become a very ritualized document. In that
section the Fed's balance of risks between growth and inflation is found. But
more importantly, it's the spot where policy makers have been signaling their
outlook for monetary policy. Since May, the Fed has been saying that "policy
accommodation can be removed at a pace that is likely to be measured," even as
they've made that statement contingent on the course of economic data.
Markets have long interpreted that phrase to mean the FOMC would lift interest
rates at each of its policy meetings for an extended period, a view Fed
officials have clearly been comfortable with. But until the release of the jobs
numbers last Friday, there's been a growing view that the FOMC might skip the
December rate hike- some Fed officials themselves indicated a pause in the rate
hike campaign might be in the offing. But the employment data washed away many
of those expectations, and a large number of major investment banks now expect
the Fed to also lift rates in December, so look for a repeat of the "measured
pace" language.

I tend to think the statements lean towards contentment with growth resuming and inflation remaining low. I would guess no acknowledgement of changing energy prices and the word measured may be dropped.

The market is now positioned for a December rate hike and to me the risk is that the statement by not confirming this view will lead to a reduction of the market probability. We shall see at 1:15.

home builder

The home builders are flying skyward today and I wanted to point out that TOL (Toll Brothers) has completed the cup and handle formation with a powerful break out.

I would also point out that the Iowa futures market had an 89% chance of a December rate hike priced in this AM. I agree that the jobs number was good but I am just not sure it was that good. It is a bit convoluted here as the stock market seems to see the economy as strong enough to handle the higher rates. I had been viewing the end of the rate hike cycle as a bullish event and I need to do some thinking about what it would mean given current expectations.

Stocks are really the wildcard as all the options seem like they should move yields higher.

Focus on the Fed!

Just for the record, the next FOMC meeting is on Nov 10. Everyone is trading opinions about whether or not the election is a cause for a rally but a change in the Fed bias is probably a better place for people's attention. In Dec 2003 the policy statement contained this remark.

However, with inflation quite low and resource use slack, the Committee
believes that policy accommodation can be maintained for a considerable period.

And in Jan 2004 it was changed to this.

With inflation quite low and resource use slack, the Committee believes that it
can be patient in removing its policy accommodation.

This change marked the end of the great bull market of 2003. Most people believe that the Fed is done with its rate hikes in November and with equal speculation circling about inflation and deflation it probably makes sense to stop here.

Whatever people may say remember that the overnight interest rate topped in May of 2000, bottomed in June 03, and is generally expected to make either a top or near term plateau next month. People may agree or disagree with Fed policy but it certainly seems to be driving the stock market.

Fed quotes and interest rate info is of course here.

Some thoughts to keep in mind

I was looking at the international charts this morning and both the FTSE and the CAC seem more like the S&P than the Dow. The FTSE actually appears to be retesting a breakout in here while the CAC is at the midpoint in a sideways range. No new lows but for the Dow.

Also, keep in mind that we are coming to the end of a hiking cycle by the U.S. Fed. The mantra don't fight the Fed was strong throughout the downtrend of 2000-01 and people got a bit tired of it. I have not really heard it once during the current cycle though the market has clearly been sailing into a headwind the last 9 months. It is still possible that we are at a point in the cycle similar to the 1994 cuts which also spooked markets quite severely. It may be that the marketing is waiting for a Fed bias change more than waiting to see who becomes the President.

Lastly the DXY is has made a straight line down to 85 and I would expect a bounce here.