The Capital Spectator

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October 31, 2005

LET'S GET REAL

There's no mystery for the labeling of inflation-adjusted yields as real yields. Real, as any dictionary will advise, is a synonym with genuine. Thus, the real, or genuine yield one could expect to receive is deflated by the inflation rate. For those intent on acquiring nothing less there are choices in the world of government paper. In one corner are the standard Treasury issues that dispatch nominal yields and so offer no protection from a future of rising inflation. In the other, Treasury inflation-protected securities, or TIPS as they're known, which deliver a real yield that buyers secure for the life of the bond.

The question of whether to choose a real vs. nominal yield arguably requires priority status these days, courtesy of the ascending state of inflation as measured by the consumer price index. September's CPI rose by 4.7% over the previous 12 months, according to the Bureau of Labor Statistics.

With that piece of consumer price information in hand, an inquiring bond investor turns to the available yields. A topical subject given that tomorrow the FOMC meets for the first time since Ben Bernanke was nominated as Greenspan's successor. Then again, the numbers are all that really matters, and on that score the benchmark 10-year Treasury looks feeble. Indeed, the 10-year yield was 4.58% as of Friday, October 28, the Treasury Department tells us. After factoring in the 4.7% rate of CPI inflation, the 4.58% Treasury yield turns into a real yield of -0.12%. Ouch!

But all's not lost. A 10-year TIPS real yield of 2.01% is also available, the Treasury informs.

How to choose? As always, start with the facts. Fact number one: a positive real yield is always superior to a negative one. By that simple logic, the 10-year TIPS is a screaming buy relative to its nominal counterpart. Indeed, locking in a real 2% yield for the next 10 years is nothing to sneeze vs. accepting inflation-adjusted losses of 12 basis points a year, as the nominal 10-year requires of new investors at the moment.

Ah, but assumptions are necessarily embedded in such a choice. Buying the 10-year TIPS assumes that inflation is going higher still, or at least not going any lower. For those who subscribe to such a forecast, snapping up TIPS makes sense.

Then again, for those who think inflation isn't destined to go higher may still think the nominal 10-year Treasury's 4.58% isn't so bad after all. And if inflation falls, and/or the economy stumbles, the capital gains that would likely accompany a nominal Treasury's future could be substantial.

So, which scenario does the market favor? By some measures, it's tough to say. Consider the returns in two iShares ETFs that are representative of each side of the inflation debate. On the one hand, the iShares Lehman 7-10 Year Treasury (Amex: IEF) has lost 98 basis points for the four weeks through October 28, according to data from Morningstar. That's a relatively better showing next to the steeper 1.58% loss over the same period for the iShares Lehman TIPS Bond (Amex: TIP). But on a year-to-date basis through October 28, the two ETFs switch spots in this relative ranking, with the TIPS ETF gaining 99 basis points vs. a lesser 56 basis-point advance in the 7-10 Year Treasury fund. In short, clear, definitive signals as to market preference about inflation's future path are missing in action, at least in the ETF niche.

So, what's an investor to do? For starters, temporarily parking money in shorter-term Treasuries and ETF equivalents may not be a bad idea. Among the choices available: a six-month Treasury bill that yields 4.22%, or just 36 basis points below the 10-year, the Treasury reports.

Such are the options in a world of flat, or nearly flat yield curves. And with the Fed poised to elevate short-term rates by another 25 basis points at tomorrow's FOMC meeting, it pays to wait another day for buying safety.

One might reasonably wonder if Mr. Bernanke's silence can be endured in the market until Greenspan steps down on January 31. With so much riding on what the new man about the Fed will or won't do, the Treasury market may be one of the less forgiving trading realms in the coming months. Nonetheless, with a small negative real current yield in the benchmark 10-year Treasury the fixed-income set isn't worried, and that worries us.

Posted by jp at 10:04 AM | Comments (4)

October 28, 2005

THE RESILIANCE FACTOR

Today's report on the economy's third-quarter performance is the first major data release since Ben Bernanke was named as Fed Chairman Alan Greenspan's successor. Will the report from the Bureau of Economic Analysis impact next week's FOMC meeting at the Fed?

The central bank looked set to raise Fed funds to 4.0% from 3.75% on November 1 even before Bernanke official become the Greenspan heir, or so the futures market was predicting. Today's release of the advance estimate on third-quarter GDP doesn't provide any fresh reason to rethink a future of higher interest rates, and arguably provides fresh reason for arguing for something more than a 25-basis point rise at the next monetary confab.

The economy grew by a 3.8% real annualized rate in the third quarter, up from 3.3% in the second quarter, BEA announced. The new GDP numbers also lend confirming evidence for what everyone already knew: inflationary pressures are on the rise. Consumers paid prices that were 4.0% higher in the third quarter, up from a 3.3% rise in the second quarter, the GDP report noted. As with the consumer price measures, however, the core rate of price changes in today's GDP news shows a lower inflation rate after taking out food and energy: a relatively mild 2.2% rise vs. an even milder 2.1% previously.

"Holy Katrina! The economy weathered two major hurricanes and in spite of that showed accelerated growth," Ken Mayland, president of ClearView Economics, said in a story this morning from AP via ABCNews.com. "I think what this shows is that fundamentally the economy was and is in really good shape."

Like Greenspan, Bernanke will have to consider the signs of sustained economic growth and elevating top-line inflation pressures and decide if it's appropriate to look only core (i.e., lower) core inflation rates. Meanwhile, there's the issue to ponder of whether to take seriously the signs that Joe Sixpack is becoming gloomier by the month. Today's release of the University of Michigan consumer sentiment index for October is the latest clue that consumers may be rethinking their profligate ways. The widely followed index slumped again this month, the third monthly decline in a row.

"Hurricane disruptions, soaring energy prices, and an endless string of Washington scandals and missteps are continuing to depress the [consumer] survey results," Michael Englund, chief economist for Action Economics, told MarketWatch.com. In the same article, another practitioner of the dismal science went further, opining that the third consecutive decline in this sentiment index may catch the central bank's attention: "...the direction is clearly something that the Fed can not be pleased with," said Stephen Stanley, chief economist for RBS Greenwich Capital.

The bond market, meanwhile, has already priced in the expected interest-rate hike on November 1. Or, if you prefer, the fixed-income set is unmoved by the latest GDP report. In either case, the yield on the benchmark 10-year Treasury logged a fairly uneventful session today by rising ever so slightly to 4.57%. In the bigger picture, however, yields are very much on the march, with the 10-year's current yield sharply up from 2005's low of around 3.8% touched back in early June. The bond market may or may not decide to continue asking for a higher premium to hedge the future, but it's clearly considered the issue of late.

The stock market, however, had a change of heart, at least for a day. The S&P 500 jumped 1.3% on Friday. It's too early to tell if this is something more than noise in an otherwise declining market. Nonetheless, it's no mean feat to pull a rally out of a hat in after a week that gave us an indictment at White House, the withdrawal of Supreme Court nominee, a very public reminder of the approaching change of Fed leadership, ongoing fallout from the devastating hurricanes, and an energy bull market that continues to roll and thereby test the consumer's endurance for financial pain.

The fact that GDP continues to impress is, well, impressive with so many negatives floating about. Equity traders can be forgiven for staying bullish, much to the chagrin of pessimists.

Hope, in sum, still springs forth. But so do the variables of contradiction, including this little tidbit to chew on over the weekend: On the one hand, short rates are rising, and more of the same is expected in Greenspan's remaining months. But a look at money supply trends of late suggest that the production of greenbacks isn't necessarily drying up, at least not as quickly as some might have expected. In fact, the rate of output is by some measures gaining momentum. Consider, for instance, that the 13-week average of M2 money supply (as published on a weekly basis) advanced by 0.12%, which tied with the previous week as the highest rate of increase in several months. That's nearly double the rate of ascent from the comparable figure for August 1. Similar, if less overt trends can be found in four- and one-week M2 averages in recent months.

A rising Fed funds rate and an accelerating pace of increase in money supply are the strange bedfellows of macroeconomics. One's eventually got to give in order to extend aid and comfort to the other. Some investors think they know which one will give first. But given all the debt that the government must finance, and social programs it must fund in the years ahead might there be an alternative monetary plan that lurking in the shadows that necessity forces upon an otherwise well-intentioned government? It may be impolite to even suggest such things in proper financial company. Nonetheless, we're just boorish enough to think that someone should bring it up in Bernanke's Senate hearings next month.

Posted by jp at 5:24 PM | Comments (0)

October 27, 2005

THE HIGH COST OF INACTION

A new oil refinery hasn't been built in the United States in nearly 30 years. If someone finds that surprising, they probably haven't been listening to the latest round of Washington chatter on the topic of creating incentives for spurring development of new facilities to meet rising demand for gasoline.

Washington is notorious as a realm where politicians rail against the oil business and complain that gasoline prices are too high. The ambitious representative or senator is keen on telling his constituency that the price is too high for filling one's gas tank, and that something, by gosh, must be done about it back at the center of the universe, otherwise known as Congress.

One solution, albeit far from the only one, is to focus Washington's powers of persuasion on pushing the energy industry to build more refineries. Heck, just one would be both progress, not to mention a major psychological break with the long history of doing nothing.

On that score, Congress has been talking a good game lately, and so has the President. "We need more supply of gasoline for the sake of our consumers and for the sake of our economy," Bush told the Economic Club of Washington earlier this week, Reuters reported via CNNMoney. "I'm going to work with Congress to pass a bill that makes it easier for current refineries to expand and encourages the construction of new refineries."

Congress, like an ornery grandfather, may or may not be inclined to go along with the idea. It all depends on the day, the mood, and the details embedded in any given piece of proposed legislation. Certainly there's no argument that the incentive to act is high these days, or at least make pronouncements from the political altar. Oil companies "need to invest in America's energy infrastructure and resources," House Speaker Dennis Hastert, R-Ill., said at a news conference on Tuesday. "The oil companies need to do their part."

Congress, meanwhile, says it's willing to do its part, but that seems to be little more than create a lot of light and heat with no tangible results. Welcome to the energy debate in the 21st century. It's a cozy little world where Congress does little more than squabbles while Big Oil reports record profits once again this week (Exxon Mobil, for instance, announced this morning that its third-quarter profits surged 75% to a record for the company of almost $10 billion, Reuters reports).

Indeed, the House passed a plan to increase oil refinery capacity last week only to watch a Senate panel kill the bill yesterday. Republic Senator Lincoln Chafee joined with Democrats on the Senate Environment and Public Works Committee, which rejected the legislation. One reason, Chafee explained, was that a plan to promote developing new refineries focuses only on increasing supply. That, of course, is what building refineries is all about. No matter, Chafee and like-minded senators want a bill that also promotes conservation. "We have failed to address our consumption," Chafee said, reported Environment News Service. "There is still time to do something in a comprehensive way." Just not today.

In fact, the refinery legislation that the Senate panel rebuffed and the House endorsed (albeit narrowly and only with Republican support) is also criticized because it reportedly compromises environmental safeguards. Whatever the arguments for defeating the latest federal effort to boost refinery development, the need for new refineries goes on. And if Washington's not up to the job, states may feel compelled to fill the void.

Consider, for instance, a report that Republican lawmakers in Iowa are considering their own approach for developing a new oil refinery in the state. "With all of the trouble that we have seen along the coasts, and we know that our coastlines are prone to damaging weather, that ends up inflicting the cost on the rest of us," said Iowa House Speaker Christopher Rants via DesMoinesRegister.com. "It would seem to us that a refinery located somewhere along the Mississippi River [in] southeast Iowa might be an ideal place in the nation to have something like that."

Ideal, perhaps, but hardly imminent. Meanwhile, the challenges in the energy marketplace roll on. The future may become strange as well as challenging on the energy front. Take yesterday's news from the Energy Department, which reported that U.S. inventories of oil rose last week to a level that's 12% above the amount from a year ago. Normally, one could say that's an encouraging sign in the battle to elevate America's supply of crude oil. But good news may be something less when considered within the context of refinery capacity that's failed to keep up with demand.

"The buildup of crude is very impressive," commodities strategist David Thurtell of the Commonwealth Bank of Australia in Sydney told AP today via CNN.com. Indeed, the inventory rise exceeded many forecasts. On the other hand, "It's not necessarily a good thing to have a build in crude," said Phil Flynn, a senior market analyst at Alaron trading in Chicago via CNNMoney.com. "It means refineries did not get up and running as quickly as hoped. It's a disturbing trend heading into winter."

This much, at least, is clear: your local representative or senator is likely to swing by soon and tell you it's an outrage that gasoline prices are so high. Talk may be cheap, but the price of inaction's soaring.

Posted by jp at 10:47 AM | Comments (4)

October 26, 2005

WAITING, WORRYING, AND REPRICING

The Bernanke era (or should we say the era of anticipating the Bernanke era?) is just about 48 hours old, but it seems intent on distinguishing itself from the Greenspan age by rousing the bond market to rethink its formerly dispassionate view of the future. Whether the new-found sobriety among those who trade debt lasts beyond tomorrow is unclear, but for now there's a new elephant in trading rooms across the country.

At one point today, the 10-year Treasury yield reached nearly 4.60%, the highest since March, and up once again from the previous day's close of roughly 4.54%. Is this a sign that the fixed-income set coming to terms with the rising inflation of late? Of course, the more topical theory is that Bernanke, for the all the accolades, remains an untested variable in the global economy, and necessarily will remain so for some time.

Uncertainty can be fertile ground for fear. "There is a degree of market uncertainty that he [Bernanke] could be less of an inflation fighter than Greenspan and the fact that he is new and untested," John McCarthy, director of foreign exchange trading at ING Capital Markets in New York, told Reuters today.

Yes, but bond guru Bill Gross, who manages the largest bond fund at Pimco, today opines in an interview with BusinessWeek that Bernanke's the "right guy." In fact, Gross goes one step further by announcing his economically amorous attraction to this right guy. "I like Bernanke better," the veteran bond manager confesses.

If Bill likes him, what's the bond market's worry? As it turns out, Gross is a touch less sanguine than the above quotes suggest. Indeed, take this tidbit from elsewhere in Gross' analysis of the pending switch at the Fed. "Greenspan's approach in terms of throwing money at the problem, lowering rates whenever there was a crisis -- it appears to have worked," the man from Pimco explained. "At the same time, it has led to a substantially leveraged U.S. economy. That's the legacy he leaves Mr. Bernanke." Cleaning up that legacy, or at least taking a stab at the task at hand, could weigh heavily on the Bernanke era when it begins in earnest on February 1.

It's been no small benefit to Greenspan's legacy that U.S. Treasury yields, despite being low on an historical basis, have been substantially higher than competing sovereign debt instruments. That's helped draw capital into the U.S. that might otherwise look for a higher-yielding home elsewhere, in turn supporting American efforts to fund its budget deficit. That's kept the applause coming for Greenspan.

Germany's 10-year bond, for instance, currently yields a relatively light 3.38%, according to Bloomberg. The Treasury yield premium is even more dramatic compared with some Asian governments, starting with Japanese bonds, whose yields look more like a crummy money market rate to the American investor's eye.

Nothing lasts forever, of course. As Nick Godt of TheStreet.com observes today, an alternative scenario may be approaching in terms of global yield comparisons as Europe and Japan show renewed signs of economic strength and markets prepare for higher yields there. To be sure, U.S. Treasuries still hold a sizeable premium advantage. But what if that advantage was trimmed only slightly but suddenly? Given the delicate balance of perceptions these days, even a small change in relative yields globally could create big changes.

No one will ring a bell when and if such changes arrive. Rather, transformations are more of an evolution than a sudden change. One could argue the evolution is upon us now in all its inglorious and muted intensity.

With that in mind, investors may want to return their gaze to the dollar for clues about what may or may not be coming. After rising for much of the past two months, the U.S. Dollar Index has stalled, and has started turning down, albeit only modestly thus far. Yet there's clearly been a definite change in momentum for the greenback, as any cursory glance at a chart of the Dollar Index will reveal. "The dollar licks its wounds in the aftermath of Tuesday’s double blow of slumping consumer confidence in the U.S. and higher than expected business confidence in Germany," Ashraf Laidi, currency strategist at MG Financial Group, writes today for ForexNews.com.

Is this the latest evolutionary signal that the forex market's getting nervous again about prospects for the buck? If so, what does this imply for bonds?

Let's be fair: the odds of Germany suddenly transforming itself into an economic thunderbolt are something more than remote at the moment. Then again, how many expected Japan to make the economic progress it has in the last 12 to 18 months?

On that note, it's worth noting that in the foreign exchange world, there are questions surrounding who Bernanke is, what he'll do (or not do), and how the global economy and financial markets will react. That's creating anxiety, suggests an AFX story today via FXstreet.com. The article quotes a Bridgewater Associates research note, which advises, "With the current imbalances in the U.S. economy, Bernanke will be walking into a minefield..."

And the poor guy isn't even Fed chairman yet.

Posted by jp at 4:42 PM | Comments (0)

October 25, 2005

READING TEA LEAVES IN THE NEW ERA

A day after Ben Bernanke was named successor to Alan Greenspan, traders of Fed fund futures reminded the Fed chairman-nominee that interest rates should keep rising well into next year. Or, perhaps traders are expecting Bernanke to take a tough stance on inflation by hiking rates in order to prove himself a muscular monetary hand early on. In any case, the price of the the April 2006 contract dropped today in anticipation of Fed funds rising to around 4.5% by next spring.

But even a higher rate wouldn't necessarily surprise Janet Yellen, president of the San Francisco Fed. Last week she was quoted by Reuters as saying that a neutral Fed funds rate, in her opinion, might be anywhere from 3.5% to 5.5% these days. Yellen's a voting member of the FOMC, which sets interest rates on behalf of the central bank. Her next opportunity to put her monetary beliefs to the test comes on November 1, when the FOMC convenes once again.

It may be a foregone conclusion that the Fed will keep tightening the monetary strings, but the Maestro in his final days on the job can expect no grace period before he leaves his post at the end of this coming January. "Be Careful, Mr. Greenspan," today writes Alan Reynolds, a senior fellow at the Cato Institute, a free-market-oriented think tank. Reynolds opines that raising rates further risks damaging the economy.

"The non-energy CPI has averaged 2.2 percent since 1996 -- compared with 5.5 percent from 1967 to 1995," Reynolds recounts. "On a year-to-year basis, non-energy inflation was still 2.2 percent the last time I checked. It was even lower if you look at a more accurate chain-weighted index, and lower still in Japan and Europe."

With the futures market expecting a Fed funds of around 4.5% early next year, and seeing additional hikes as 2006 unfolds, there's a danger that the central bank will go too far. "Unless something unexpected happens to lift the non-energy CPI above its stubborn 2.2 percent trend, a 4.5 percent funds rate suggests a real interest rate on cash of about 2.3 percent. That's not the end of the world, Reynolds admits, noting that the comparable real interest rate hit 3.5 percent in 1990 and 2000, in both cases just ahead of a recession. "Unless bond yields rise substantially, however, a funds rate of 4.5 percent or more would nonetheless be higher than the yield on 10-year Treasury bonds. By this measure, the yield curve would be at best flat and probably inverted," he observes. "That has never happened in the midst of an energy price spike without the economy slipping into the tank. Never."

Whether any of this has any influence on Fed policy in the future remains to be seen. Meantime, the issue of non-core CPI vs. top-line CPI rears its ugly head. Indeed, Reynolds correctly points out that inflation's a mere 2.2%, to judge by core CPI. Yet headline inflation at last count is 4.7% (the highest since 1991), above the current 10-year Treasury yield of around 4.53%, which, by the way is up by roughly nine basis points today from the previous close. The sharp rise in energy prices accounts for the higher top-line CPI number.

Meanwhile, The Times in Britain published an interview with Bernanke that was conducted last week, on October 18, just a few days before Bush chose him to take over Greenspan's job. Among Bernanke's comments to the Times: "I have confidence the Fed is going to remain vigilant and ensure inflation is contained within the more volatile energy sector." In addition, "I don’t think either an upsurge in core inflation or a recession is a likely consequence of what we have seen."

Do those comments last week reveal Bernanke to be someone who thinks headline inflation is the true measure of price trends? Or is he more of a core-inflation man? Inquiring bond traders want to know.

Posted by jp at 5:05 PM | Comments (0)

October 24, 2005

WELCOME TO THE JUNGLE

The long wait for a name is over. Now begins the long wait to see how the new kid on the block performs.

Meanwhile, we have the president's assurances. "Ben Bernanke is the right man to build on the record Alan Greenspan has established," Bush said today in his announcement that the chair of the White House's Council of Economic Advisors has been nominated as successor to the demigod Alan Greenspan, otherwise known as the chairman of the Federal Reserve.

The nomination surprised no one, as Bernanke has been widely rumored to be on the short list of people who might be called upon to take over the most powerful central bank on the planet. With rumor replaced by fact, a new season has begun in trying to answer the question: Who is this man, and what will he do?

For those who watched the President's announcement on television, it was hard to miss the other man in the room, namely, Greenspan, whose presence seemed to imply that the maestro approves of his would-be replacement. Presumably, the Senate will fall in line as well when it eventually votes on the Bernanke nomination.

And on paper, at least, what's not to like? Bernanke was a Fed governor prior to appointment to the White House's CEA earlier this year. The presumed next Fed chairman is a Harvard graduate and was chairman of Princeton University's Economics Department. It's an impressive resume, to be sure. The question is whether Bernanke, or anyone for that matter, is up to the job of taking over the nation's monetary strings from a man who's widely celebrated as the best that central banking has produced.

By some accounts, Bernanke's the right man at the right time. “He's eminently qualified for the job," Avery Shenfeld, senior economist at CIBC World Markets, tells The Globe and Mail today. "He's a leading macro economist at the academic level and has all of the background needed to be the Fed chair. He's also someone who, by being an outspoken but brief member of the Fed, was also someone who financial markets had been able to get comfortable with." Meanwhile, Peter Morici, a professor at the University of Maryland, writes in MarketWatch.com that Bush is giving Wall Street what it wants: an inflation hawk.

Nonetheless, there's still that shadow. Although Greenspan has many critics, it's beyond debate that the Maestro's influence has been second to none in calming and charming Wall Street when necessary, bucking up support for this or that White House policy initiative, and generally influencing public opinion on a range of issues. Does Bernanke hold such powers of persuasion? Will he even try? Should we care?

Too early to tell. For perspective, it's worth reminding that Greenspan's initial arrival as Fed head in 1987 was less than universally accepted. Coming after the towering Paul Volcker, who broke inflation's back in the early 1980s, Greenspan was seen as something less than Volcker, which was a backhanded insult at the time.

Then came the stock market crash of 1987, and Alan's moment to shine arrived. And he passed the test with flying colors by opening the financial spigots at a moment of financial distress of a degree unseen since the Great Depression. A student of economic history, Greenspan was careful to avoid the Fed's past mistakes, namely, the monetary tightening of the early 1930s, an act that some say turned what would have been a recession into something materially worse.

Only fate knows if Bernanke will have an opportunity to prove his mettle with the markets. For now, he's an obscure man to the masses, but one who's known to the world of finance for his tough talk on deflation and an affinity for inflation targeting, i.e., a controversial rules-based approach to managing the nation's money supply.

Yet Bernanke says he plans no policy revolutions. "If I am confirmed to this position," Bernanke said with the Maestro and the President by his side today, "my first priority will be to maintain continuity with the policies and policy strategies established during the Greenspan years." But lest anyone think the nominee will simply be a caretaker chairman following in the shadow of his predecessor, Bernanke assured that Fed policy "will continue to evolve in the future."

Still, the equity market seems pleased with the Bernanke announcement (the S&P 500 climbed 1.7% today). By contrast, the bond market prefers caution: the yield on the 10-year Treasury moved up a bit today to close the session at around 4.45%.

Perhaps the fixed-income set realizes that inflation is no less a threat now than it was before the White House announcement. Bernanke, meanwhile, has recently gone on the record as saying that the current uptick in inflation is nothing to worry about. "Inflation is up, driven by energy prices," Bernanke said on October 12, Dow Jones reported via CNNMoney. "Underlying core rates remain low, which is encouraging."

Encouraging? An alternative view is that it's only a matter of time before the core rate follows the path of the top-line inflation rate. If so, it wouldn't surprise Bernanke's critics to learn that the Fed nominee stumbled on forecasting the inflationary risks of the future. "He's been wrong about what's happening with inflation for two years," Josh Stiles, senior bond strategist at IDEAglobal in New York, says of Bernanke in a Reuters story today. "He's more focused on structural disinflation forces than he is on the cyclical inflationary forces from excessive accommodation."

Regardless of who's Fed chairman, the years ahead will almost surely require a different central bank strategy compared with what's been deployed in the past. Inflation in the last 20 years was more or less falling. Inflation's no longer falling, and it may very well be rising for more than a short period of time. That, combined with a new man at the Fed, creates a cloud of unknowing.

"There's more uncertainty with Bernanke than with Greenspan," Bill Gross, chief investment officer at Pacific Investment Management Co., said in a Bloomberg News story. Today's selloff in Treasuries "was not an expression of dissatisfaction with the choice but merely a reflection of the uncertainty."

Posted by jp at 5:29 PM | Comments (3)

October 21, 2005

LIFE BEYOND THE 10-YEAR

Yield competition is the new new thing for the fixed-income market. With inertia dominating trading in the benchmark 10-year Treasury Note of late, yield-hungry investors who think bond traders are asleep at the switch may be inspired to look for more alluring quarry elsewhere.

As it happens, there's opportunity for improving one's fixed-income status these days. Yields for 10-year municipal bonds, for example, are nipping at the heels of the 10-year Treasury. The national average for investment-grade A-rated investment-grade muni bonds yesterday was 4.2%, according to FMSBonds.com, a muni broker. That's a mere 23 basis points below the 10-year Treasury's current yield of 4.23%, according to Bloomberg data. In fact, that tax-free muni yield may actually be higher relative to the Treasury Note after adjusting for the IRS pinch that accompanies the federal government's debt.

Meanwhile, taxable short-term instruments are looking more competitive these days as well. Consider the national average for five-year certificates of deposit, which currently offer a 4.16% rate, reported Bankrate.com. That's just seven basis points below the 10-year Treasury's yield, and it comes with a lock-up period of half the time.

Meanwhile, the Treasury's pre-scheduled adjustment on November 1 for inflation savings bonds promises to be another yield-enhancing experience for investors considering the choices in the fixed-income realm. The current I-bond rate is 4.8%, advised Bankrate.com. But after the November 1 adjustment, which factors in the inflation rate of the previous six months, the new I-bond yield will jump to 6.9%, said Dan Pederson, author of "Savings Bonds: When to Hold, When to Fold and Everything In-Between," via Bankrate.com.

Because inflation has marched higher in recent months, based on the consumer price index, the I-bond will reflect the trend with higher yields. The CPI advanced 4.7% during the 12 months through September, sharply higher from the 3.3% rise reported for 2004, for example.

Money market rates are still materially lower than the 10-year Treasury's current yield, though not by much if you're willing to shop around. The national average yield for bank money market accounts is a paltry 2.22%, according to Money-Rates.com, although a look at individual institutions reveals a wider range yield choices among banks, including one as high as 4.03% at one relatively generous outfit.

In fact, the plain vanilla money market fund is positioned to become an increasingly popular item for the foreseeable future if the Federal Reserve keeps raising rates. To judge by trading in the Fed funds futures market, such a future seems likely. The March 2006 contract, for example, is priced for a 4.4% Fed funds rate, or significantly higher than the current 3.75%.

True, money market rates are relatively low compared to long-term fixed-rate debt securities. But money market funds enjoy a trait that promises to among the more popular devices in the financial universe for the foreseeable future: a yield that keeps pace with the trend du jour with the overall price of money. Don't try that with your conventional Treasury Note.

Posted by jp at 10:26 AM | Comments (0)

October 20, 2005

HIGH ANXIETY

Inflation is said to be a monetary phenomenon, or so monetarists like to say. But today's October manufacturing survey from the Philadelphia Fed suggests that strengthening economic activity and rising prices aren't necessarily strangers.

"The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, increased from 2.2 in September to 17.3 this month," the Philly Fed reported today. "The 15-point rise returns the index close to its level in August." Meanwhile, firms surveyed reported another month of higher production costs. "The current prices paid index rose 15 points, following an increase of 27 points in September, and is now at its highest reading since November 1980," the October survey advised. "Sixty-eight percent of the manufacturers reported higher prices for inputs, up from 57% last month. No firms reported declines in input prices." If that wasn't enough, the survey also noted that higher prices for manufactured goods were becoming more common, implying that higher costs are finding their way into the consumer market.

Might any of this scare the bond market? Not a chance. The yield on the benchmark 10-year Treasury Note remains as nonchalant as ever these days, ending today's trading at roughly 4.44%, or about where it's been all week. True, the yield's up from around 4.0% since the end of August. Will that rise suffice as enhanced compensation for what awaits in pricing trends? Perhaps, although one can still obtain virtually the same yield in the two-year Treasury relative to its 10-year counterpart.

In short, the 10-year offers a bare 21 basis points in yield premium over the two-year Treasury. Why would any one buy the former over the latter? The answer lies with expectations, of course. Even a 21-basis-point yield advantage adds up over ten years. Of course, that's assuming the current yield in the 10 year doesn't rise.

Nice work if you can get it, although in listening to Fed officials of late one could be forgiven for expecting higher yields of no trivial degree down the road. "It was Janet Yellen, president of San Francisco Fed, and Governor Ferguson speaking [on Tuesday] about the importance of keeping inflation contained," wrote Northern Trust economist Asha Bangalore in a research note yesterday. In fact, Bangalore continued, "the Fed is focused on preventing temporary price pressures from translating into persistent inflation. The risk of higher core inflation has risen as energy prices have posted sharp gains for several months and the futures market points to energy prices staying at elevated levels."

Of course, with today's drop in oil prices one could argue that it's time to rethink the energy threat. But with so much conflicting data spewing forth, it's getting harder to decide just what the path of least resistance is for the economic big picture. On the one hand, there's reason to think that inflationary pressures will soon ebb, based in part on falling oil prices since September. In fact, crude dropped again today, at one point dipping below $60 a barrel, the lowest in three months. The oil market, at least, is starting to buy into the belief that U.S. economic growth will temper in the near future.

Adding to the belief that the economy's due to slow, and thereby lessen pricing pressures, is today's' report from the Conference Board, which announced that September's leading index of economic indicators dropped sharply last month--the third consecutive monthly decline.

But if a slowdown is coming, there's scant sign of it in the latest batch of jobless applications. Filings for unemployment fell for the second week in a row last week, the Labor Department reported. Adjusting for the additional claims created by Hurricane Katrina reveals a labor market that retains a fairly healthy glow. "The Labor Department estimated that Katrina and Rita added 40,000 to the latest weekly claims reading of 389,000, making the clean read 315,000," wrote David Resler, chief economist for Nomura Securities in New York, in a research note to clients today. "That keeps adjusted claims running near the lower end of its one year plus range for the second week in a row. The clean read again points to labor markets maintain their robust health."

The bond market nonetheless betrays no fear of late. (Or is it simply looking at economics data on a selective basis?) In any case, the stock market, by contrast, looks increasingly anxious. Indeed, the S&P 500 fell 1.5% today, putting the index within shouting distance of its lowest levels since May. Meanwhile, equity market volatility is now on the rise. It's a great time to be a trader once again, but buy-and-hold investors may face more than their fair share of choppy markets as the year winds down.

Posted by jp at 5:25 PM | Comments (0)

October 19, 2005

OILY BUBBLES

Is the bull market in oil history?

More than a few investors have suffered from believing in no less at various points in the last few years. When a barrel of oil changed hands at $30, many said it would never reach $40. When it did, $50 a barrel was thought to be impossible. When $50 was crossed, the shock and awe was even more potent, as it was when crude passed through $60, and when it recently touched $70. The sight of dowdy oil-company shares climbing right along with crude's price was equally surprising for many investors.

Now that the bull market in energy is accepted wisdom, is it time to throw it out, if only for a time? It's a bit easier to argue in today that the head of steam that oil prices have maintained in recent years has evaporated. Crude, as we write in mid-afternoon New York time, is down by more than $1 a barrel to around $62. That's well below the $70.85 intra-day peak reached in September. Perhaps more importantly, the low-$60 reached of late has come without much fanfare, and in a slow but persistent downward spiral, suggesting that speculators are unwinding positions.

To be sure, there's news weighing on crude's price these days, starting with forecasts that Hurricane Wilma approaching the U.S. is now expected to avoid delivering any major damage to energy infrastructure in the Gulf of Mexico. Adding to the selling mood is news today from the Energy Department that crude inventories in the U.S. rose more than expected last week. The 5.6 million-barrel advance for the week through October 14 moved the total up to 312.0 million barrels, which represents "the upper end of the average range for this time of year," the government explained. In addition, OPEC announced that its current production capacity would jump by around 17% in five years, Bloomberg News reports.

With the major oil companies set to report third-quarter earnings next week, speculation about where energy equities go from here, having already left most other sectors in the performance dust this year. The energy sector in the S&P 500, for instance, posted a 27% rise in 2005 through yesterday, according to Standard & Poor's data. None of the other nine sectors that comprise the S&P 500 even came close. In fact, the second-best sector so far this year (utilities) posted a respectable but still distant 9.8% year-to-date rise. Next is health care, up 1.7%. The remaining seven sectors all suffered losses so far in 2005.

Energy stocks clearly look good in the proverbial rear-view mirror, but can they keep the party going on a relative and/or absolute basis? BCA Research asked as much the other day when the shop opined: "The sharp rise in long-term earnings expectations for global oil & gas stocks makes them more vulnerable to a pullback in energy prices."

Now comes yet another research report raising questions, this time from Neil McMahon, Sanford Bernstein & Co.'s oil man in London, who warned in a report today that next week's earnings reports from Big Oil will "disappoint." With a forecast that's 10% below the consensus outlook for biggest oil firms, McMahon is effectively sounding the alarm. It's "our belief that one outcome of the quarterly reporting season is likely to be weakness in upstream realizations due to lost production from high margins areas, significantly lower marketing margins, weaker chemicals earnings and increased costs all of which indicate negative earnings surprise," he wrote to clients today.

What's that you say? Energy stocks will stumble with earnings relative to what the crowd expects? Say it ain't so. Alas, McMahon, who's gotten more than a few things right in the 21st century in forecasting the oil sector, gives aid and support to those looking for an excuse to cash in their oil-equity winnings.

Yes, the long-term geological forces are still in play, which is to say that finding oil isn't getting any easier. That's unlikely to change any time soon, if ever. But don't expect that backdrop to automatically translate into easy and continuous earnings gains each and every quarter for every oil company, he implied.

McMahon also suggested that in the long run, the ascending challenge of finding big new oil fields might actually work against some oil companies, particularly those that aren't able to replace reserves. Essentially, the cost of searching is going up in a world where the low-hanging fruit has been picked. Accordingly, there's a declining payoff from all the increased spending on searching. As McMahon observed, "With increased capital expenditure being directed towards exploration, the integrated oil group has yet to come up trumps, and the scramble for LNG [liquefied natural gas] positioning and oil sands acreage/companies by the group begs the question…are they really covering up for poor exploration success?"

The first of many clues arrives next week in the form of earnings reports. To judge by Wall Street, however, optimism still burns bright. "Eight of the 14 top-ranked industry groups [based on earnings expectations] for this week are oil-related," according to a report published Monday by Zacks. "Within those eight industry groups, there has been 307 full-year earnings estimates revised upwards versus 102 revised downwards – a ratio of 3-1."

In fact, Exxon Mobil Corp., Chevron Corp., BP, ConocoPhillips Co. and Royal Dutch Shell are expected to report a $9 billion, or 43 percent, rise in their combined third-quarter profits, according to analysts' estimates compiled by Thomson Financial, reports AP via Star-Telegram.com. "They are just printing money right now," oil analyst Fadel Gheit at Oppenheimer & Co. in New York tells AP. "They are making so many trips to the bank because they can't take all the money there at one time."

A correction in oil stocks may be coming, but for the moment the crowd doesn't see it. Of course, the crowd didn't see the bull market in energy either.

Posted by jp at 6:25 PM | Comments (3)

October 18, 2005

WHO MOVED RISK'S PAYOFF?

Risk is taking a beating these days. Reaching for higher performance by way of greater risk is a time-honored means of boosting profits, of course. But the strategy can also bite back in times of uncertainty or worse, as this year's performance in various corners of the equity market suggest.

Consider that large-cap stocks are still in the black this year. The Russell 1000 posted a slight gain of 0.6% year-to-date through October 17. Small caps, on the other hand, have shed 2.1% over that stretch, based on the Russell 2000 index. And the truly tiny companies, represented by Russell Microcap, have fared even worse, losing 3.5% in 2005 through yesterday's close.

Is the fact that risk isn't rewarding investors this year a sign of tougher times ahead? What is Mr. Market telling us? Whatever it is, are investors inclined to listen?

In search of answer, keep in mind that when the stock market finally rebounded after equities collapse in 2000-2002 risk lived up to its billing as a returns booster. From December 31, 2002 through the end of last year, for instance, smaller was definitely better. The Russell Microcap earned an annualized total return of 32.1% over that two-year span, well ahead of the small-cap Russell 2000's 26.6%, or the Russell 1000's 16.7%.

But risk seems to have fallen out of favor this year, as year-to-date performances tallies imply. What might save equities from stumbling further? Continued earnings growth would help. But is earnings momentum up to the task at this point in the cycle?

Don't write off more earnings growth just yet, wrote Ed Yardeni, chief investment strategist with Oak Associates, in an email to clients today. "Last Friday, I raised my forecasts of analysts' consensus expected S&P 500 12-month forward earnings from $83 and $89 by the end of 2005 and 2006, respectively, to $85 and $91," Yardeni advised. "In other words, I predict that at the end of this year analysts will project that earnings will be $85 in 2006. At the end of next year, I predict that they will expect $91 for 2007."

Assuming that the S&P 500's current price-earnings ratio of 14 (by Yardeni's calculation) holds, the index would rise 7% between now and the end of 2006. If the Fed stops tightening, the p/e could rise to 16 (as Yardeni expects), in which case he thinks the S&P 500 would climb by more than 20% between now and 14 months hence.

One reason for remaining bullish is that once the Fed ends a cycle of interest-rate hikes the stock market responds with a rally, Yardeni added. "Since 1960, the S&P 500 has rallied 5 out of 9 times by an average of 7.5% and 14.1% three and six months later, respectively," he reports. "The four times the market fell after the rate peak, the average drop was 5.0% and 5.1% three and six months later. The market's P/E rose 6 out of 9 times following major cyclical peaks in the fed funds rate."

Mr. Market, however, was in no mood for optimism today. Losses dominated trading in equities today. Consumer discretionary companies were especially hard hit, shedding nearly 4% on the day. This despite the news today that sales at retail chain stores rose 0.4% last week, according to the International Council of Shopping Centers via Reuters. "Although consumers are still very worried about the sharply higher energy expenditures impacting their budgets, they also seem to be spending a bit more over the last four weeks, which is an encouraging sign," said Michael P. Niemira, ICSC's chief economist and director of research.

Suffice to say, as the holiday shopping season is set to begin in earnest, analysts will be watching Joe and his neighbors closely to gauge consumer sentiment where it counts most: spending. If Yardeni's bullish expectations are to have any chance of becoming reality, it's a safe bet that consumers will need to keep spending at a healthy pace through the end of the 2005. In turn, the willingness to spend will depend in no small way on energy markets.

Virtually every observer of the economics scene has been shocked and awed by Joe's ongoing enthusiasm for spending in the face of price spikes in oil, natural gas and gasoline. In earlier time, energy bull markets of this magnitude have turned otherwise bright-eyed consumers into frightened souls intent on little more than wearing an extra sweater and riding bicycles to work.

But that was yesteryear's response to energy shocks. Nonetheless, even in this era of heroic consumerism a pullback in energy prices could hardly come too soon to insure survival for the retail industry's holiday season. Alas, no sign of a pullback today, with crude oil prices rising sharply once again in New York futures trading.

In any case, Joe's maintained his lifestyle thus far, preferring to assume more debt rather than let the energy bull market spoil his party. Might there be more of the same on tap? Perhaps, but the risk of something else is rising. Top-line inflation rising, and so is unemployment (albeit modestly thus far). Joe's biggest hurdles, in short, may be yet to come. To judge by the relationship between risk and reward in the stock market, however, the jury's left the seats and is preparing to leave the courtroom. Or, as Bob Dylan once sang, "It's not dark yet, but it's getting there."

Posted by jp at 4:37 PM | Comments (1)

October 17, 2005

SUPERPOWER COUNSELING

No one will confuse China with the United States, but Treasury Secretary John Snow is working on it.

Based on the secretary's comments on his latest trip to the Middle Kingdom, China's consumers are spending fast enough to buy TVs, cars, and other goodies. And that irks America's Treasury chief. "Developing a stronger consumer credit system in China will be important in helping to facilitate the further development of the country," Snow advised reporters last week, according to ChinaDaily.com. How magnanimous of him to say so. Indeed, he suggested that China's "extraordinarily high" savings rate wasn't being deployed as productively as it might be.

Might Snow have any ideas on how to solve this thorny problem? Indeed he does. In a word, his strategy boils down to this succinct message for Chinese consumers: buy. The secretary, of course, comes from a nation that excels in just that. Nobody does it better. Whether the secretary's advice will find any traction in China remains to be seen, but Snow's doing his best to induce just that. Why? Simple, really. To quote the Treasury boss from AP via the International Herald Tribune: "As China moves toward a more consumer-based society, the savings rate will go down and consumers will spend more, allowing China to buy more from the United States."

Buying more from America will, in turn, help close the ever-rising trade deficit. In August, nearly one-third (31%) of the U.S. trade deficit was with China, according to the Bureau of Economic Analysis. Joe Sixpack is less than inclined to cut back on his purchases here in these United States. Perhaps, then, his Chinese counterpart can do his part to cure the global economic imbalance.

Secretary Snow's previous efforts to compel China to let its currency float according to supply and demand was designed for much of the same intent, namely, closing the U.S. trade deficit. A pessimist might find reason to fear such a future, assuming that the bond market ever decided to worry over this mounting pile of red ink. The thinking at Treasury goes like this: a floating Chinese currency would lead to a stronger yuan, which would then make U.S. exports to China more attractive by way of lower prices. The flip side: Chinese goods are less attractive to American buyers by way of higher prices, as per a rising yuan. In short, floating the Chinese currency might very well solve America's trade deficit.

But China, being nobody's fool when it comes to unsolicited economic advice from Superpower nations, let its currency float albeit within a narrow range, thus far. America's long-running lecturing to the Chinese about the value of free-floating currencies turned out to be less than the red-ink killer some thought it might have been.

On to phase two of curing the U.S. trade deficit, this time by pushing the better-living-through-buying sermon.

It should come as no surprise that the United States is becoming more sensitive to resolving such formerly low-priority challenges as rising trade deficits. What garnered precious-little notice yesterday now grabs more than passing notice at the highest levels of government.

What's changed? America, for one, is an economy where both inflation and unemployment are on the march. (Consumer prices last month advanced 1.2%, more than double the 0.5% rate logged in August, while the jobless rate in September advanced to 5.1% from 4.9% in the previous month.) It may be too early to decide if these twin demons are set to take wing for the foreseeable future. But for the moment, they're climbing, and in the past that's been no trivial affair in the realm of politics.

One might recall that a simultaneous ascent of inflation and unemployment was, in an earlier age, dubbed the rise of the misery index. The fact that this ignominious measure is again making threatening gestures creates problems, if only temporary, for the Federal Reserve in that it reduces the monetary options. If America's jobless rate is rising, the central bank may feel compelled to lower short-term rates at some point. But in a world where the U.S. trade deficit is rising, long rates may start rising. Talk of inverted yield curves is nothing new of late. But what about talk of a deeply inverted yield curve? The monetary rock and the hard place may yet be sidestepped.

Not to worry. The bond market isn't yet inclined to sell and run. The yield on the benchmark 10-year Treasury Note barely budged today, closing the session at around 4.49%. But the future may become more complicated, as some U.S. lawmakers weigh their options and monitor the political winds. Indeed, talk of imposing trade tariffs on China are gaining attention and rattling cages. Secretary Snow even felt compelled today to comment that Senate legislation calling for a 27.5 percent tariff on all imports from China in the absence of more currency reform was "ill-conceived," according to Xinhuanet via ChinaView. What's more, he extended that observation/warning from Beijing, an odd but otherwise practical locale given the political/economic context at the moment.

The global economy, in short, may be more dependent on consumerism and free trade than you think.

Posted by jp at 9:14 PM | Comments (2)

October 14, 2005

A NEW INFLATION REPORT, SAME OLD DEBATE

It has a familiar ring to it: top-line inflation is surging as the core rate (less food and energy) remains eminently well behaved. As such, investors are still stuck with the recurring conundrum: which gauge of inflation holds the truth?

Casting one's lot with one side or the other promises to be no trivial decision given the stark difference between the two measures of inflation. The top-line consumer price index advanced at 1.2% in September, the Labor Department reported today-- more than double August's 0.5% advance. Ah, but extracting food and energy from the mix reveals that consumer prices were barely moving last month, registering a mere 0.1% increase, a fraction of the top-line's growth.

Looking at the annual rates of CPI's change doesn't mitigate the disparity between top-line and core rates of change. The unadjusted CPI rose by 4.7% for the year through September 2005, or more than double the 2.0% rate for core CPI. (For perspective, the latest report shows the U.S. economy growing at an inflation-adjusted annual rate of 3.3%, which is obviously well below the rate of top-line CPI's advance.)

How does the enlightened investor interpret the variance? Very carefully. Indeed, there is no obvious consensus. Rather, partisans on either side of the debate are actively recruiting for their respective outlook. The pessimists, of course, warn that inflation's on the march. Recent CPI reports, they say, confirm the obvious. It's time to take defensive action now, they counsel. Indeed, many already have, as the rising price of gold in recent years suggests.

Then there are the optimists, as we shall call them, a plucky group that holds fast to the belief that energy (which is the primary variable driving top-line CPI skyward) is a temporary phenomenon that long-term investors needn't fear. A combination of technology, new oil- and natural-gas field discoveries, development of alternative energies, enhanced conservation will save us, along with an enlightened group of central bankers. What's more, in the shorter term, energy is a bubble, we're told. A slowing economy will pare marginal energy demand, setting prices for oil and other petroleum products on a downward path. In fact, the price of a barrel of crude oil in New York futures trading has been slipping since the end of August, giving aid and comfort to the notion that the cycle shall soon set us free by putting more discretionary spending income in our pockets through lower fuel costs.

Both the bond and stock markets this morning seemed all too eager to align themselves with the cause of the optimism. In the wake of the CPI's 8:30 a.m. release today (New York time), all the major equity indices were modestly up at 10 a.m. The bond market too was inclined to see the sunny side of the inflation report (such as it is) and chase the 10-year Treasury Note, thereby pushing its yield down slightly by mid morning relative to yesterday's close. Even gold traders appeared on the fence this morning, with the price of the precious metal off slightly in early trading. The triumph of the optimists resigns supreme as we write.

But what does it say about either optimism or pessimism on the matter of the future path of inflation when no less an informed player in the financial system than the president of the Federal Reserve Bank of Kansas City is less than confident about what's required of the central bank for the foreseeable future to nip any inflationary pressures in the bud. "My goal is the maintenance of a stable price environment, with low and stable inflation, because I think that is essential to having sustainable growth," Thomas Hoenig told Reuters yesterday via The Washington Post. "And I think that we need to do what is required in order to achieve that goal." So far, so good. And what, if we may be so bold as to inquire, might that task entail? "What is required to achieve that goal," Hoenig continued, "is still open to analysis, to the collection of information and to the application of judgment on the day that the decision is required, which is Nov 1," he said in reference to the next interest-rate-setting Federal Open Market Committee meeting.

No matter what Hoenig says, or doesn't say, the fact remains that inflation's at a 25-year-high in the United States. Some might see that as a sign. In an earlier time, such news would suggest an obvious response. No more. This is the age of financially correct speaking (and thinking?). The question before the house: What's it going to cost us in the long run?

Posted by jp at 10:53 AM | Comments (4)

October 13, 2005

AMAZED & ASTONISHED, BUT NEVER SURPRISED

This morning's Labor Department report on import and export prices is sure to re-energize the debate about whether rising energy prices are more than a short-term inflation threat. But while the dismal scientists will squabble about what awaits in the long run, the here and now offers clarity in abundance.

Consider that U.S. export prices rose 0.9% in September as import prices surged by 2.3%. The 2.3% spike is the highest monthly increase for import prices since October 1990, the Labor Department notes. The ignominious point alone makes it hard to dismiss the inflationary pressures suggest by the numbers.

Reviewing the import/export details doesn't help. Indeed, energy prices last month were the primary culprit driving import prices higher. And since America relies increasingly on foreign oil to feed its petroleum fix, energy and import prices are likely to be forever joined at the hip, for good or ill. For the moment, it's all for ill, with petroleum import prices generally soaring 7.3% last month vs. just 1.2% for non-petroleum items. In fact, energy's import price index has, for the fourth month running, set a new high since the data series was introduced in 1982.

"The spike in energy prices and the aftereffects of Hurricane Katrina filtered through to import prices very quickly," observes David Resler, chief economist at Nomura Securities in New York, in a research note sent to clients today. So, is it time to start worrying in earnest about inflation? That depends, Resler advises, on where energy prices are headed. No one really knows, so the answer necessarily remains elusive.

Nonetheless, it's a sign of the times perhaps that the bond market is no longer waiting for definitive proof, or so suggests the rise today in the 10-year Treasury yield at one point to 4.5%, the highest since this year's first quarter. Was this just a passing anxiety attack that, like so many in the past, will quickly fade? Or, has the fixed-income set finally decided to get off the bench and make a decision about the morrow?

Regardless, the threat of higher interest rates is now compelling enough to neutralize other news. Case in point: forex traders were buying dollars today, effectively ignoring the Commerce Department's report that America's red ink in trade continues to mount. The U.S. traded deficit deepened to a negative $59.0 billion in August, $1 billion more than in July. Jay Bryson, global economist at Wachovia Securities, writes today that "the increase in the deficit was not nearly as large as most market participants had expected, leading the dollar to strengthen in the immediate aftermath of the data release."

In early Thursday trading, the greenback reached a two-year high against the yen, for example, compelling one currency manager to proclaim that America's paper money was second to none (again) in the world financial system. Alas, the reason for the bullishness on the buck is something less than encouraging outside the forex world, namely, the rising price of money. Nonetheless, Paresh Upadhyaya, a currency manager at Putnam Investments, told Bloomberg News today that "the dollar is king," explaining: "The market is focused on cyclical themes, meaning higher interest rates in the U.S." Meanwhile, Masanobu Ishikawa, general manager at forex broker Tokyo Forex & Ueda Harlow, tells AP via SanDiego.com that "the Federal Reserve has made it very clear that interest rates will continue to rise this year, which makes it easy to buy the dollar."

The dollar also managed to get another leg up on the euro today, in part thanks to fresh news of Europe's challenges in the realm of economic growth. The euro-zone economy grew at just 0.3% in the second quarter, down from 0.4% in the previous quarter, the Eurostat statistics agency said today in a press release. That compares with 0.8% for the U.S. in the second quarter.

Expectations of higher U.S. interest rates seem firmly grounded, and increasingly potent. For some speculators, there is no other news. But the tunnel vision won't last forever. Trade deficits and other challenges shall be heard, later than sooner, perhaps. But heard, nonetheless. Just one glimpse of what may lie ahead comes from none other than a currency strategist who, of course, pored over today's trade report for August. Yes, the deficit was less than expected, to judge by the consensus prediction, even though it was bigger than July's. "But what's more interesting is the U.S.-China deficit, especially with what's going on in Beijing just now," Rebecca Patterson, currency strategist with JP Morgan in New York, tells Reuters. "It's going to put a lot of pressure on the U.S. to get China to move [further on yuan flexibility], and to the extent that they don't, that's going to raise protectionist rhetoric in Congress, which I think is ultimately dollar-negative."

As it happens, Treasury Secretary John Snow is in China at the moment, and his agenda goes well beyond sightseeing. A chat with China's president Hu Jintao is on the docket, and the subject of yuan flexibility is sure to get another airing between the two. So far, the Treasury Secretary has been quite the diplomat, dispensing such observations of the Middle Kingdom as: ''I'm astonished every time I come to see how much has happened since the last time I came,'' Snow said, as per AP via McCall.com. Compared with a visit a decade ago, ''the changes are nothing short of breathtaking," Snow exclaimed.

If Snow's observations were meant to compel the Chinese to introduce more yuan flexibility, the gambit isn't paying off. As Reuters reports today, "Chinese Finance Minister Jin Renqing on Thursday snubbed U.S. demands for faster currency reform, saying the country will liberalise the exchange rate in its own time and in line with its own interests." No word yet on whether Snow was "astonished" by China's snub. And just for good measure Jin told reporters: "Using revaluation of the renminbi to resolve global imbalances, particularly the imbalances of certain countries, is impossible and also unnecessary."

No matter, as the dollar's still generally up against most major currencies as we write this afternoon. Now isn't that astonishing?

Posted by jp at 2:09 PM | Comments (1)

October 12, 2005

DATA MASSAGE

Statisticians like to say that if you torture the data long enough it'll confess, which is a cute way of saying that you can prove almost anything if you play with the numbers. But data massaging can be a two-way street. If the creative mind can manipulate data, there's also the possibility that the data is less than pure before the analyst starts to work on it.

The issue of misleading numbers comes up anew with the recent government revisions to gross domestic product data for the past three years through this year's first quarter. For example, growth of the GDP price index over the three-year period was raised from two percent to 2.3 percent, reports the St. Louis Fed in its October issue of Monetary Trends. Another adjustment includes the “core” personal consumption
expenditures (PCE) price index, which is among the Fed's preferred metrics for assessing inflation.

"Although the core PCE price index was revised upward by only about 0.25
percentage points to about 1.75 percent over the three-year period, what is perhaps worrisome is that the largest revisions to the core PCE inflation rate have occurred since mid-2003," writes Kevin Kliesen, an associate economist with the St. Louis Fed, in Monetary Trends. "This is the period when monetary policy was characterized as accommodative and economic growth was generally robust. From 2003:Q2 to 2005:Q1, the annualized growth rate of the core PCE price index was revised up 0.5 percentage points to 2 percent."

Does this mean that monetary policy was more accommodative than originally billed? And if so, does that mean that the monetary tightening now under way should be more aggressive, run longer, or both in order to correct for past data sins?

It's a question worth pondering once you realize that the real (inflation-adjusted) Fed funds rate has been lower than government data previously suggested. The disconnect between what was reported and what now appears to have been unfolding was at its worst in late 2003 through early 2004. The government data dispensed at the time showed a real Fed funds rate rising, moving from negative to positive. In other words, it appeared that the central bank was substantially tightening the monetary strings when in fact, based on the revised data, the exact opposite was in progress, i.e., the real Fed funds rate became more negative (or more "accommodative") for a time.

Kliesen observes that "current estimates show that a negative real Federal funds rate persisted until the December 2004 meeting, probably a more stimulative stance than the FOMC intended. While the policy implications of this particular data revision
may not be large, it nevertheless reinforces the difficulties that FOMC policymakers confront when implementing policy in real-time." And, we might add, it's no picnic for bond investors either.

Calculating what a debt security worth is tough enough in the best of circumstances, thanks to the ongoing mystery otherwise known as the future. As it turns out, the past isn't necessarily crystal clear either. Knowing that, who'll step right up and take a guess at whether the current yield on the 10-year Treasury (roughly 4.44% at the close of today's session) is overvalued, undervalued, or fairly value?

Posted by jp at 4:52 PM | Comments (2)

October 11, 2005

BACK IN THE SADDLE AGAIN

There's "no doubt" that the Fed will raise its benchmark short-term interest rate to 4.0% at its November 1 FOMC meeting from the current 3.75%, wrote Asha Bangalore, a Northern Trust economist, in a research note on Friday. Mr. Market concurs, based on the November 2005 Fed funds futures contract, which is priced in anticipation of 4.0%, as of today's close. The momentum won't stop there, the futures market also predicts. Drawing on the current price of the March 2006 contract, even higher rates await beyond the next FOMC meeting next month.

If fear of flying is the standard response for some as they ponder of world of higher rates, relief seems to capture the emotion elsewhere in the financial universe. The U.S. Dollar Index in particular is all too happy to hear that the price of money is on the march. Indeed, the greenback today continues to rebound after last Thursday's dramatic 1.3% stumble. Since then, the Dollar Index has recouped its latest stumble, and then some.

Thanks go in part to the Federal Reserve, the new best friend of forex traders. "The reason the dollar is staying strong is because markets have continued to price in more Fed tightening,'' Daniel Katzive, a currency strategist in Stamford, Connecticut at UBS AG, tells Bloomberg News.

Adding to the momentum for the buck's new-found strength was today's release of the minutes from the Fed's last interest rate-policy meeting in September. Talk of higher interest rates is almost as potent as the actual event, and the central bank is making full use of the verbal tool these days. "Participants' concerns about inflation prospects generally had increased over the intermeeting period," the minutes advised. "The surge in energy prices, in particular, was boosting overall inflation, and some of that increase would probably pass through for a time into core prices."

It didn't hurt the dollar's bullish cause today with new that political troubles may rise anew in the largest national economy that claims the euro as legal tender. Reports that Angela Merkel will be Germany's next chancellor added to the skepticism that surrounds Europe of late. Merkel's ascent came with the heavy price of compromise among the various political parties that agreed to vote for her (Germany's being a parliamentary system of government). Historic though her advance is (she's the first woman to head the government), some critics charge that the "grand coalition" that lends political life support will sanction precious little economic reform efforts going forward. That's something less than good news for a country, and a continent in desperate need of economic restructuring. Or so the prevailing wisdom asserts, based on the euro's sharp decline today.

"The dollar's gains are pretty much broad-based, with losses being led by the euro," David Mozina, head of New York foreign exchange strategy at Lehman Brothers in New York, told Reuters. "The belief last week that things are going to be pretty good in Germany is now starting to be wound back, given that the conditions that Merkel had to agree to become chancellor are not good."

If you thought any of this would impact the yield on the 10-year Treasury Note, think again. Indeed, the benchmark government bond continues to be unaffected by political or economic news, good or bad. The fixed-income set on the long end of the curve now seems immune from any and all news of any sort. The 10-year currently offers a yield of roughly 4.39%, virtually unchanged from Friday's close (Monday was a holiday in U.S. government bond trading).

How long can the 10-year stand aloof from events unleashed? Tough to say, although as long as government bonds retain an ample supply of foreign sugar daddies, why worry? Indeed, a recently published working paper published on the Fed's web site claims that the 10-year's yield would be an earth-shattering 150 basis points higher if not for the kindness of offshore strangers. Meanwhile, no word yet on whether all the foreign buyers of dollars have read the paper.

Posted by jp at 4:33 PM | Comments (1)

October 10, 2005

RESEARCH ROOM UPDATE: CURVACEOUS FINANCE

Gazing at the shape of the yield curve offers no promises on divining the future, but investors are nonetheless well advised to monitor the evolving relationship among the interest rates tied to the various Treasury maturities. On that score, the pressing question on this Columbus Day is whether a flattening yield curve will give way to an inverted one, a state of affairs in which short rates exceed long rates. Indeed, the 10-year Treasury, as we write, claims only an 18-basis-point premium over its two-year counterpart, according to Bloomberg. If and when the 10-year's slim edge dips below that of the two-year's yield, would such an unnatural state of pricing money signal trouble for the economy? In fact, each of the last six recessions have been preceded by such an inversion, advises a freshly minted primer on the curves of yield, courtesy of Arturo Estrella, an economist at the New York Federal Reserve Bank. "The Yield Curve as a Leading Indicator" reviews the obvious questions, and then some on the subject at hand. This tidy bit of research and summary, delivered in a user-friendly question-and-answer format, also offers a healthy bibliography for those inclined to dig deeper. No, the piece won't extend absolute clarity about the morrow, but it sheds light on the relevance of yield curves as a forecasting tool. A fresh look at the topic couldn't come at a more timely moment, and so CS today adds the paper to the Research Room.

Posted by jp at 3:31 PM | Comments (0)

October 7, 2005

DID SOMEONE SAY "BOO"?

The bond market as yet is unmoved by the current round of inflation talk, but the dollar and its arch nemesis, gold, are sensitive to the chatter.

Yesterday was a potent reminder of the sensitivity that permeates the world of money, fiat and real, when the inflation monster is invoked, or gently reviewed. Indeed, the greenback suffered its biggest daily decline against the euro in three years, notes Ashraf Laidi, a forex strategist at MG Financial Group. The U.S. Dollar Index took it on the chin as well, reversing several weeks of increases with a sharp drop yesterday.

For the casual observer, the selloff in the buck might appear odd, given that it was the European Central Bank that yesterday felt uncompelled to fight inflation with stronger medicine. As such, the ECB left its benchmark interest rate unchanged at 2.0%, a level that's prevailed since June 2003. By contrast, the Fed has been busy burnishing its inflation-fighting credentials of late by raising interest rates consistently for more than a year, albeit in baby bites of 25 basis points at a time.

All things being equal, relatively higher interest rates tend to support a currency. But all things are not equal, nor does equality in matters financial and economic look set to pay a visit any time soon, if ever. Taking a stab at the always thankless task of explaining Mr. Market's behavior, one observer put it this way: "The higher rate theme [in the U.S.] is offset by fears that inflation may move higher and growth may move lower," Gavin Friend, currency strategist at Commerzbank in London, told Reuters today.

The gold market could hardly agree more, given that the price of the precious metal, jumping nearly $6 an ounce yesterday to $475, puts the commodity near a 17-year high. In today's session, the metal added more ground, closing up $2.90 to $477.90.

But in the spirit of the times, the dollar complicated the market scene today by staging a rebound of sorts. Just when you thought it was safe to sell the back, the gremlins of surprise came rushing back to the fore, leaving speculators reason anew to scratch their heads this weekend in search of definitive answers about the morrow.

Whatever the reason, the greenback rallied on Friday, recovering about half of what it lost on Thursday against the euro. (Volatility, at least, remains in a bull market.) The dollar's burst of strength is all the more puzzling in that it comes in the face of gold's continued climb higher today.

Perhaps we can dismiss the buck's bounce as a relief rally in that the payroll report for September showed only a mild loss of employment in the U.S. Nonfarm payrolls slipped 35,000 last month, a trifling fraction of the 200,000 decline expected, according to Briefing.com. In line with that slight setback, unemployment for September moved up a bit as well to 5.1%, from 4.9% in August, the Labor Department reported.

All in all, not bad, considering the wreckage from the two hurricanes Katrina and Rita. Unless, of course, you're of a mind to think that the jobs report is less than fully representative of what took place last month. With so many displaced workers roaming around, trying to make sense of the devastating losses from the twin storms, checking in with the local unemployment office may not be high on one's list at the moment. Losing a job is no fun, of course, although it hardly compares to losing a house or a family member.

In any case, we return to the question that's likely to preoccupy us over the weekend, namely, Is the inflation scare over as far as market action is concerned? Perhaps, although we'll await next week's market reaction for confirmation or rejection.

On that note, it's worth reminding that a key driver of rising inflation fears of late--energy prices--resumed its familiar bullish posture today, with the price of crude oil rising by around 80 cents a barrel to $61.84. That inspired the buying of energy stocks, which had taken a beating earlier in the week. The S&P energy sector roared higher today by 2.25%, putting to rest for the weekend at least that the bull market in oil shares is over.

As the boys of Buffalo Springfield once intoned, "Something's happening here, but what it is ain't exactly clear."

Posted by jp at 7:48 PM | Comments (1)

October 6, 2005

BETWIXT & BETWEEN

If and when inflation strikes, history suggests the assualt’s anything but ambigious. No one debated if inflation was a bonafide menace in the 1970s, to cite the obvious example. But clarity of that sort, either confirming or denying inflation’s presence, may be a luxury in the 21st century. Instead, we can look forward to death by a thousand forecasts, and more than a little uncertainty from the numbers.

Accordingly, the jury’s still out on whether inflation’s a threat at all. Depending on the day, the economic news ebbs and flows, giving aid and comfort to one side of the debate, only to retract the support the next day by way of contradictory data.

After yesterday’s ISM services sector survey for September, the specter of inflation and recession simultaneously—stagflation--has again been cited as a lurking shadow. “Until recently, investors generally assumed that soaring energy prices wouldn't upset Fed policymakers as long as core inflation remained subdued, which it has until now,” Ed Yardeni, chief investment strategist for Oak Associates, wrote in an email to clients this morning. “Of course, the best way to make sure that energy costs don't drive up core inflation is to raise interest rates high enough to bring energy prices back down, or at least stop them from going any higher.”

Grappling with the question of whether inflation’s a threat, and what to do about it, if anything, is the new new challenge for central bankers. The European Central Bank is struggling with that question. That stuggle today emerged as a decision to stand pat on interest rates, however. The ECB announced on Thursday that its main refinancing rate will remain at 2.0%, as it has since June 2003. The reasoning is that Europe’s sluggish economy trumps mounting inflationary pressures. Nonetheless, Eurozone inflation in fact rose last month at its fastest pace in more than a year to an annualized rate of 2.5%, up from 2.2% in August. But as the Financial Times today reports. But picking one’s poison is required these days. As such, the ECB chooses to worry that high energy prices will further constrain economic growth on the Continent, thus the verdict to keep interest rates at 2.0%.

The Federal Reserve is faced with a similar set of macroeconomic choices, but comes to a different conclusion. Rather than focusing on an economic slowdown, either real or perceived, the Fed’s intent on fighting the rise in top-line inflation, and so has been raising interest rates since June 2004.

Pundits debate about whether the ECB or the Fed will be the first to reverse course and follow the other’s path. But for the moment, there’s more than one way to interpret the economic winds blowing.

At the heart of which view carries more intellectual weight lies the subject of rising energy prices, and the associated question of whether one should dismiss or accept the threat. Depending on your response, inflation in the United States looks either threatening or contained. For example, inflation (measured by the consumer price index) advanced by 3.6% for the year through August, according to the Labor Department. Stripping out food and energy—resulting in the so-called core rate of inflation—leaves a much lower pace of inflation, rising by just 2.1% over the same span.

The gulf between the two rates can be mostly explained by energy. Indeed, the energy component of the CPI soared by more than 20% for the year through August, by far the biggest rise of any component impacting the government’s calculation of consumer prices.

Considering the Fed’s recent bias for monetary tightening, Greenspan and company appear inclined to see the top-line inflation rate as the primary danger. In fact, Philadelphia Fed President Anthony Santomero said as much on Tuesday, when he explained, by way of Reuters via The Washington Post: "To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one.”

If that was too subtle, Dallas Fed Bank President Richard Fisher sharpened any smooth edges today by asserting that the central bank must stop an "inflation virus" from attacking the U.S. economy, according to Bloomberg News. Inflation, he said, exhibits “little inclination” to slow and in fact is approachign the “upper end of the Fed's tolerance zone.”

Interest rates, it seems, will continue rising for the foreseeable future in these United States. That is, until they stop rising. In the meantime, Mr. Market will be looking for any signs that the Fed’s preference for fighting inflation rather than recession as the primary goal for monetary policy. For the moment, however, he’s just asking the question and not getting a lot of definitive answers. Case in point: today’s mixed results from a September report on sales results from retailers as a reason to continue wondering what comes next. No wonder the 10-year Treasury’s yield, at 4.37% at the end of today’s session, was virtually unchanged from yesterday.

Don’t just do something, stand there!

Posted by jp at 7:37 PM | Comments (0)

October 5, 2005

RETHINKING MONDAY

Talk about mixed messages.

Just 48 hours after the Institute for Supply Management reported that manufacturing activity in September was much stronger than expected, ISM today released its September survey for the services sector only to contradict Monday’s encouraging news. "ISM's Non-Manufacturing Business Activity Index in September dropped to 53.3 from August's 65, indicating a slower rate of growth of activity in September,”the press release advised. Although 53.3 still indicates growth, the index fell last month to its lowest reading since April 2003.

Still, it’s unclear if the drop is a harbinger of things to come, or just a one-time event. More data, as always, is required. Meanwhile, thanks to the hurricanes, and a few other gremlins, economics suffers a less-than-textbook existence these days. Whatever the future holds, the services sector promises to remain on the frontline of any trend change if for no other reason than it represents the lion’s share of economic activity in the U.S. relative to manufacturing.

On that score, pessimists will pay close attention to the fact that real estate, business services and finance & banking are among the groups within the services sector report “decreased activity” to ISM last month. Such news seems destined to fuel speculation that the real estate market’s bubble, if in fact that’s what it is, is set to burst. That, in fact, seemed to be the fear driving today’s tumble in shares of home builder Hovnanian Enterprises Inc., which fell 91 cents to $48.37. A noteworth decline considering that the company reported that the dollar value of its new contracts rose 68% last month. Alas, bullish news must pass through Mr. Market’s increasingly skeptical eye on matters of property booms.

Even a more moderate reading of today’s ISM report has to consider the prospect of slower economic growth. "Many [ISM] members' comments expressed concern about the continuing increase in oil and gas prices as well as Hurricane Katrina, and their impact on prices and economic activity," Ralph Kauffman, chair of ISM's nonmanufacturing business survey committee, said in today’s accompanying press release.

Optimists will point out that while the services sector has slowed, it’s still growing. That’s just what Kauffman emphasized. Again, quoting him from today’s prepared statement: “The overall indication is continued economic growth in the non-manufacturing sector in September, but at a slower rate of increase than in August."

One economist was a bit less forgiving in assessing the news: “The services economy had the wind knocked out of its sails in September,'' Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi Ltd. in New York, explained today to Bloomberg News.

Putting a positive spin on the prices paid in the services sector was materially more challenging. Indeed, prices paid last month rose materially faster in September vs. August, reaching the highest level recorded since the ISM’s non-manufacturing survey began in 1997. Adding salt into the price wound, ISM also reported that the percentage of members reporting higher prices rose to 58% from 36% previously. All of which suggests that pricing pressures are on the march.

Perhaps the warning signs embedded in today’s ISM report will pass, perhaps not. That, in short, is the question of the moment, namely, “If and when manufacturers and businesses decide they have to pass through these rising prices to consumers,” Jerry Zukowski, deputy chief economist at Nomura Securities International Inc., told AP today via MSNBC.com. “A lot of it is energy. We are clearly not out of the woods in terms of these price pressures.”

The bond market, however, is still willing to withhold judgment, one way or the other. The yield on the 10-year Treasury slipped only slightly today, closing the session at 4.35%. The stock market, by contrast, took the news from the ISM harder. The S&P 500 shed 1.5% today, dropping to its lowest level in months.

So, who’s right? Monday’s manufacturing report? Today’s services numbers? The bond market? The stock market? Consensus may be lacking, but choice stretches to the stars.

Posted by jp at 4:45 PM | Comments (0)

October 4, 2005

ONE MORE DIP?

Don't let yesterday's surprisingly upbeat manufacturing news for September fool you. The economy's set to stumble, and perhaps fairly soon, triggering another descent in long-term interest rates, or so warns Pimco's Bill Gross in his latest missive.

There are several potential catalysts for the pending stumble, Gross writes. The list of gremlins includes energy prices, China’s economy, and interest rates. Then there's real estate, he adds. "Make no mistake about it, the froth in the U.S. housing market is about to lose its effervescence," Gross predicts. "The [property] bubble is about to become less bubbly. If real housing prices decline in the U.S. in 2006 or 2007, a recession is nearly inevitable. If higher yields simply slow the pace of appreciation to a more rational single digit number, then we could escape with a 1-2% GDP economy."

Either scenario will bring lower interest rates, Gross concludes. Timing, as always, is open to debate.

If the Fed will soon start lowering rates, the clues at present are still missing, suggests BCA Research in a report last week. "A flurry of speeches by Fed officials in the past two days have confirmed the message delivered at the September 20 FOMC meeting: the reduction in growth caused by Hurricanes Katrina and Rita will be temporary and the Fed must continue to tighten monetary policy," BCA counseled on September 30.

The bond market of late seems inclined to agree with BCA. Yesterday's ISM Manufacturing report for September, which registered a sharp gain from August, has further stoked the fires of optimism for the notion that the economy's not dead yet. The benchmark 10-year Treasury Note's yield of roughly 4.36% at mid-morning today was near its highest in months, according to data from BarChart.com. As recently as late August, the 10-year's yield was briefly under 4.0%.

"The market is still adjusting to the fact that it has underestimated the strength of the economy,'' Thomas Roth, head of Treasury bond trading at Dresdner Kleinwort Wasserstein Securities in New York, told Bloomberg News earlier today.

Adding insult to injury to the bond bulls' ego is today's stronger-than-expected factory orders report for August. New orders for manufactured goods in August, the Census Bureau reported. That's well above the consensus forecast of 2.0%, according to TheStreet.com.

Yes, the factory orders report reflects mostly pre-Katrina trends. But the post-Katrina numbers so far don’t seem to be suggesting anything less, based on yesterday's ISM Manufacturing release. What's more, early signs of the global economy's post-Katrina trends depict growth as the path of least resistance. "September data suggested that the trend in global manufacturing operating conditions recovered sharply, supported by robust growth of new business and production," observes a report published yesterday from JP Morgan.

To be sure, the risks that Gross points out are hardly worthy of dismissal. Real estate in particular may or may not be a bubble, but signs that its momentum may be slowing are emerging. "A real estate slowdown that began in a handful of cities this summer has spread to almost every hot housing market in the country, including New York," reports The New York Times (free subscription required) today. Whether this is a sign of tougher times ahead in real estate, or merely a pause that refreshes, remains to be seen.

In the meantime, the burden of proof remains on the shoulders of the bond bulls, at least for today.

Posted by jp at 11:22 AM | Comments (2)

October 3, 2005

ECHOES OF JOHN D.

Oil companies are making fists of money these days, courtesy of the energy bull market. Of course, the notion of Big Oil flush with profits doesn't sit well with the public, which is paying through the nose to drive. But in a nod to political correctness (or should we say, energy correctness?), Big Oil's voluntarily trying to hold down prices at the local gas pump.

It's not a completely altruistic move. What's lost in terms of maximizing revenue might be picked up in market share, or so some are suggesting. The Wall Street Journal (subscription required) over the weekend reported that gasoline sold at the likes of Exxon Mobil and Valero Energy, for example, can be relatively less expensive than at some other stations. "In essence, these giants are using robust refining margins to challenge their competition." Mary Rose Brown, a spokeswoman for Valero, the largest independent refiner in the U.S., was quoted in the article, explaining: "We've made a decision to lag [behind] the market."

The pricing discipline inspired Tom Kloza, chief oil analyst for the Oil Price Information Service, to opine for the Journal, "The majors are practicing defacto price regulation."

Keeping prices artificially lower than they otherwise might be, albeit only modestly thus far, is less than critics of the oil industry expected. Responding to the-then proposed merger of Exxon and Mobil in 1998, BBC News sniffed that "the consolidation of the oil industry will reduce competition in the market and could lead to higher prices at the petrol pump as the new industry Goliath's wield their increased power."

ExxonMobil's predecessor parent, John D. Rockefeller's Standard Oil, was in fact broken up by the government a century ago, in part for the crime of buying up the competition and becoming a monopoly, a feat that subsequently allowed the energy goliath to lower the prices of oil and related products and beat back the would-be contenders in the process.

"Economists have picked apart Standard Oil's bookkeeping entries and concluded that, in fact, Rockefeller paid fair sums for the companies he bought and undercut prices by brilliantly increasing efficiency," wrote Todd Buchholz in a review (free subscription required) of The Tycoons in Sunday's New York Times Book Review. "Rockefeller's competitors were scattershot operations. He beat them by building his own pipelines, manufacturing his own barrels and negotiating volume discounts with the railroads." As a result, the price of kerosene, a staple energy source back in the day, dropped by 60% in the 1880s, Buchholz observes.

Don't hold your breath for a similar decline in oil prices any time soon. Meanwhile, Big Oil's still becoming more efficient, in part out of necessity. That's life when your commodity of preference is a diminishing resource.

As for the stigma of lowering prices by wielding corporate power and efficiency, that's no longer a public disgrace, or so one could argue. As we write, we know of no marches in the Capitol to protest Exxon's price-lowering scheme. Juicy profits from oil refining, however, are still reviled by everyone but the shareholders. Some things, at least, never change in the oil game.

Posted by jp at 11:12 AM | Comments (1)