May 31, 2006
MAY'S RED INK
What Mr. Market giveth, he also taketh away. That was mostly true for this month, as the chart below documents. The high-flying asset classes were generally the ones that suffered the most in May, as of yesterday's closing prices.
The primary exception was commodities. A high-flying asset of late, by any measure, but one that also led the pack in producing what was otherwise in short supply in May: robust positive returns.
Our measure of commodities is the PIMCO Commodity Real Return Strategy fund, which tracks the Dow Jones-AIG Commodity Index. By this gauge, May was in fact merry, with the mutual fund advancing 1.95% for the month.
On the opposite end of the performance spectrum is the sharp loss for emerging markets stocks, which retreated by 12.6% this month through yesterday, measured here by the iShares MSCI Emerging Markets ETF. But even that deep cut has yet to knock the asset class from its perch as the best performer over the past year. Emerging markets equities may be suffering these days, but in the race over the past 12 months they're still far and away the top dog.
The question, of course, is what comes next, and on that score there is always far less clarity compared with dissecting what's just passed. In any case, perhaps this is a timely moment for a strategically minded investor to ask if momentum has legs in bear as well as bull markets.
Asset class proxies: Vanguard REIT Index VIPER, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov't Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities, PIMCO Commodity Real Return Strategy.
May 30, 2006
THE TROUBLE WITH SPAM...
The exploding volume of spam posted in our comments section has forced us to ask our legitimate commentators to sign in via Typekey (a free service, as you'll see when you post a comment but haven't yet subscribed). Alternatively, you can simply send an email to The Capital Spectator, which we'll post manually. Sorry for the inconvenience. Such is life in the 21st century.
A THOUGHT EXPERIMENT ON FORECASTING INFLATION
Mr. Market has been wearing optimism on his sleeve when it comes to estimating the future path of inflation by way of the spread between nominal and inflation-indexed Treasuries with 10-year maturities. But the optimism that has been fashionable this season past may fall out of favor this summer as inflation fears heat up.
As of last week's close, the nominal yield on a 10-year Treasury was 5.06%, according to the databank maintained by the U.S. Treasury. The 10-year inflation-indexed Treasury (or 10-year TIPS, as everyone likes to call them) ended the week at 2.44%. The spread between the two was 2.62% (5.06 less 2.44). In other words, Mr. Market's forecast of inflation is 2.62%, as the chart below illustrates.
How high is 2.62% as an inflation forecast? Arguably, not high enough, even though it represents the upper range based on the last three years, and up about 30 basis points from 2005's close. But on one level, at least, 2.62% as an inflation expectation appears more than a little dovish. We come to the conclusion by pointing out that 2.62% is considerably below the 3.5% current annual pace of increase in consumer prices.
Granted, there are several ways the imbalance can be corrected, which, we're confident, is coming. The means for the correction, as well as its timing, are the great mysteries, although we have our suspicions on those fronts as well. In any case, a wider spread between the nominal and TIPS yields might be forged with more than a little selling in the nominal Treasury.
In order for the nominal/TIPS spread to match the current annual rate of CPI increase, the 10-year Treasury's 5.06% would need to jump to 5.94% (assuming last Friday's TIPS yield remained unchanged). The drawback to such an alignment would entail the bond market getting crushed, to use the technical term for heavy selling.
An alternative scenario would no doubt be preferable to the fixed-income set, at least temporarily, although it's not entirely clear such an outcome is imminent. Nonetheless, if TIPS buying surged, and in the process decreasing the associated yield to 1.56%, the expected inflation outlook drawn from the nominal/TIPS spread would match the latest annualized pace of CPI's increase (assuming the nominal yield remained unchanged).
Of course, this is the moment in our essay to point out that any robust buying of that degree in the TIPS would eventually (if not immediately) gain attention in the capital markets far and wide, thereby sending an inflationary warning whose repercussions would likely echo bearishly in the pricing of other yield-sensitive instruments.
Of course, the optimists are quick to point out that the third way for the inflation outlook born of the nominal/TIPS spread to come into line with CPI is for the latter to fall. By that reckoning, the current 3.5% CPI rate would be required to descend to the 2.6% range, give or take. For the sake of historical perspective, the last time CPI's annual pace paid a visit to that neighborhood was June 2005, when consumer prices advanced 2.5% over the year-earlier month.
Or, perhaps some mix of all three will arrive.
So many variables, so many possibilities, although in the end it all boils down to the simple question: Are you bullish or bearish on bonds?
May 26, 2006
THE CONUNDRUM CONUNDRUM
In order to know what is going to happen, one must know what has happened.
The "conundrum" of low bond yields in the face of rising inflation and a robust economy may be yesterday's news, but a consensus on the causes remains elusive. Indeed, one of the more common explanations--foreign central bank buying, particularly from those in Asia--wasn't the cause after all, according to a new research paper by economists at two Fed banks, which we'll get to in a minute.
But first, it's worth noting that the ignorance could be a problem for monetary policy in the future. If the forces behind the conundrum aren't understood, those forces may yet come back to bite Bernanke's Fed. How can you manage something you don't understand? The answer, of course, is that you can't. And if you can't understand the forces affecting monetary policy, the risks are higher that your policy could run amuck and dispense effects into the economy that are unnecessary or even dangerous in the pursuit of a stable and low-inflation, a stable currency, and so on.
It's hardly comforting to know that former Fed head Alan Greenspan chose the word "conundrum" to describe the capacity for long yields to stay low when the central bank tried to engineer a higher price of money. The idea that a mysterious but powerful force is rewriting market rules for the global economy should give both investors and central bankers pause.
What you don’t know can hurt you when it comes to deploying monetary policy. That starts with allowing inflationary forces to take root when one might suppose otherwise. Another skulking threat might be the nurturing of speculative bubbles when the Fed intends nothing of the kind.
There is no shortage of opinions about why long rates--which are set by the marketplace--stayed so low for so long, much to the Fed's consternation. Fed Chairman Bernanke, before he reached his current exalted position, opined as a Fed governor that a "global savings glut" was the source of the conundrum. A more ambitious explanation came from Christopher Probyn, chief economist for SsgA, who last year wrote that the low yields were a byproduct of a "confluence of forces, including the transparency of monetary policy, contained inflationary expectations, pension reform, foreign central bank demand for U.S. securities, a new government deficit financing strategy, and the shift to floating rate debt." Perhaps he should have simply blamed the global economy.
But is it really that simple (or complicated)? Not necessarily. Consider a more modest analysis of what's going on, which comes by way of a new research paper penned by economists at the San Francisco and Dallas Fed banks. In fact,
The Bond Yield Conundrum from a Macro-Finance Perspective is notable for what it doesn't find: easy explanations.
Although the paper's models document that the low yields of 2004 and 2005 were "unusual," the variable showing the most explanatory relevance, albeit a small one, "is declines in the (short-run implied) volatility of long-term Treasury yields…. Even so, at best, almost two-thirds of the conundrum remains unexplained."
The most-provocative part of the paper's conclusions is what it didn’t find, namely, that foreign central bank buying of Treasuries explains the abnormal persistence of low yields in 2004 and 2005. "Large-scale purchases of long-term Treasuries by foreign central
banks," the authors write, "has essentially no explanatory power for the conundrum episode."
The paper concludes by putting a positive spin on the mystery. "The resolution of these "conundrum" episodes, in the U.S. and abroad, presents a rich frontier for future research." Somehow, we suspect that Bernanke and company will have a slightly different reaction.
May 25, 2006
TIME TO PUT THE PAUSE ON PAUSE? MAYBE, PERHAPS, POSSIBLY
Today's upward revision in the pace of growth in first-quarter GDP shows the economy expanding at its fastest rate in more than two years. That should give the Federal Reserve something to talk about as it ponders what to do at its next monetary policy meeting on June 28-29.
Bernanke and company keep reminding that they need more data to make an informed decision on the next move (if any) on interest rates. By that standard, can we assume that the Fed is now one step closer to putting the pause on pause and raising Fed funds next month?
Last month, when the first guess of 1Q GDP was dispatched (the "advance" estimate, as it's known), we were told that the economy grew by a robust annualized 4.8%. Today, we learn that GDP was rolling along at a materially faster pace: 5.3%. The "primary" reasons for the upgrade, the Bureau of Economic Statistics says, was a higher increase in inventories and stronger exports that initially estimated.
In any case, an economy growing by 5.3% is an economy that's expanding at a rate that exceeds the current Fed funds rate by more than a trivial gap. Perhaps it's time to rethink if the central bank's monetary policy is at or near a state of neutrality. Even if the Fed were to elevate rates by 25 basis points come the end of June--as it's been doing at every FOMC meeting since June 2004--Fed funds would still be trailing GDP's pace for the first three months of this year.
But as any dismal scientist will tell you, GDP reports--even upwardly revised ones--are yesterday's news, or, more precisely, the previous quarter's news. The question is whether the obviously strong first quarter momentum will spill over into the second quarter and (dare we ask it?) the third quarter? On that all-important question the jury is out, at least when it comes to trying to forge a consensus. And since the first guess at second-quarter GDP doesn't arrive until July 29, the opportunities for conjecture are wide open on matters economic.
Indeed, a contemporary sampling of prognostications suggests no less. For instance, Chris Low, chief economist at FTN Financial in New York, tells Bloomberg News today, "So far, the economic data we've seen for May are shaping up a lot weaker than we expected, and if that continues the Fed can pause."
Meanwhile, David Resler, chief economist at Nomura Securities in New York, this morning writes in a note to clients that his outlook for materially slower economic growth of 3.1% in the second quarter remains unchanged despite today's GDP report.
But another analyst comes leans in the opposite direction, warning that the economy's is in no danger of stumbling. The upward revision in 1Q GDP "helps undermine the recent exaggerated fears in the market that economic growth is slowing sharply," Dick Green of Briefing.com tells BBC News today. "Market fears of a sharp slowdown in economic growth, or even of a recession, are unwarranted."
Recession or expansion may be in the mind of any given beholder for the moment, but Mr. Market is nonplussed with the GDP news. As we write this morning, the 10-year Treasury yield, at 5.03%, is virtually unchanged from yesterday's close. Ditto for the June Fed funds futures contract, which continues to be priced in anticipation that the Fed will keep rates unchanged at the June FOMC meeting.
Perhaps the prudent thing to do is take a page from the Bernanke handbook and wait for more data, starting with the third and final update for 1Q GDP. As fate would have it, it's due for release on the morning of June 29, just a few hours ahead of the FOMC's announcement on interest rates. Is that too small a window of time to influence monetary policy that day? One would think. Then again, perhaps a few hours is all the Bernanke crew needs to rethink a rate decision if the final 1Q GDP imparts fresh and previously unsampled insight. Welcome to the age of monetary policy in real time.
May 24, 2006
THE SCIENCE OF GUESSTIMATING
What good is transparency if the future's unclear? Not much if you're turning over stones in the bond market in search of clues about what's coming.
Fed Chairman Ben Bernanke has been warning that the central bank is more or less making monetary policy on the fly these days. As new numbers on the economy come in, the Fed will adjust its monetary prescription accordingly. Gee, thanks.
If it's not already obvious that ours is a great moment of transition, Bernanke reminded everyone of this fact in his testimony yesterday to the Senate Banking Committee. On the subject of the next interest-rate meeting on June 28-29, he advised that "we have about a month to go before the next FOMC meeting and a lot of data between now and then. We will be watching that data very carefully," reports Reuters. In other words, the Fed may hike rates but perhaps it won't.
The bias was on the side of pausing earlier this month. Where did Mr. Market get that idea? From the Fed, of course, which explained in its May 10 FOMC statement that "some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information."
The notion that the Fed would take a breather in raising rates has found traction in the bond market. Although the yield on the 10-year Treasury moved higher in the two days after the May 10 FOMC meeting, it's been coming down since then. The fact that this morning's report on April's new orders for durable goods was surprisingly weak only adds momentum to the case for lower yields. But if you're feeling optimistic, today's April's new home sales' release--which dispatched an unexpectedly robust gain for the month--is just the thing.
For every bull, there is a bear these days, each armed with data supporting their case. If there's a belief that a 5.0% Fed funds rate may be the high watermark for awhile, there's a competing school of thought that thinks any effort to halt the rate hikes at this juncture is a mistake. A glimpse of this opposing army of hawks was seen yesterday, when sellers gained the upper hand in fixed-income trading by delivering one of the more convincing jumps in yield in recent memory. The 10-year's yield at one point yesterday was as high as 5.08%, a sharp rise from Monday's intraday low of 4.99%.
Higher rates are eminently reasonable, advises David Gitlitz, chief economist of TrendMacrolytics. Writing in a note to clients yesterday, he opines that "the bullish case for bonds is essentially built on the same flawed logic that drove the short-lived
yield curve inversion earlier this year, and we expect this episode to end no better for the bulls."
Gitlitz, as you might have guessed, is skeptical of forecasts calling for a weakening economy, the driving force for buying bonds and thereby lessening yields. If the economy stumbles, monetary tightening will quickly become déclassé for fashion-minded central bankers. But Gitlitz thinks that the so-called smoking guns supporting the economy-is-slowing school aren't really as potent as they appear. Meanwhile, "An avowedly 'data dependent' Fed, we think, will remain in rate-hiking mode for at least the next few meetings as the data will give very little support to the economic bears," he predicts.
In any case, choosing sides on the economy's near-term future seems to be essential decision of the moment for dictating investment success and failure. Perhaps the extraordinary challenge that awaits in getting this bet right is suggested by Bernanke's preference for a wait-and-see approach to policy pronouncements. If the Fed is playing its cards close to the vest, maybe no less is prudent for everyone else. On the other hand, with the central bank sitting on the fence, espousing clarity holds the potential for looking like a hero--if you're right.
As for Mr. Bernanke, one might ask if monetary policy--a tool that invariably has a long-term influence--should be driven by short-term decisions. Yes, it's possible that between now and the end of June that earth shattering economic changes that no one saw coming will arrive. But don't hold your breath. Any one data point is but the tip of the economic iceberg. Surely the Fed, with all its resources, has an inkling of where the world's largest economy is headed and what the inflationary trends will be. Then again, maybe not. This, after all, is the age of conundrums.
History reminds that the Fed has a history of making poor, even disastrous policy judgments, the early 1930s and the 1970s being the obvious examples. But the central bank isn't likely to repeat such mistakes. The solution, however, may be no less risky. Indeed, the risk of choosing the wrong policy at the wrong time may be yesteryear's problem, but the Fed may go to the opposite extreme by exercising extreme and perhaps imprudent caution and inaction when something more is warranted.
There are no free lunches in the 21st century. Risk, on the other hand, remains an enduring force, albeit in evolving forms.
May 23, 2006
DOWN BUT NOT YET OUT
Everything's down, but discriminating among equity sectors still has its merits. In fact, one could reason that selectivity becomes that much more critical if the downturn in the stock market is more than just a temporary setback. Genius is a bull market, an observation that's delivered no small advantage in recent years. But an eye for finding pearls among swine may be due for a comeback as a favored investment skill.
As you might expect, the broad-based selling of late has dispensed varying degrees of red ink across the ten major sectors that comprise the S&P 500, as the chart below illustrates. So far in May, information technology has suffered the biggest loss, tumbling 7% this month through last night's close, according to Standard & Poor's. The relatively conservative utilities, by contrast, have been pinched the least, posting a stumble of just two-tenths-of-one-percent. Overall, the stock market (measured by the S&P 500) has shed 2.5% in May.
In the search for investment justice, some may look for signs that the highest flyers of the large-cap equity sectors so far this year have taken the toughest punishment this month. But the record is mixed on that score. Indeed, the worst-performing sector (information tech) in May is also the big loser year to date through yesterday. Meanwhile, the second-biggest year-to-date winner--industrials--has endured one of the milder sell offs so far this month.
Justice, such as it is, is most obvious among the energy stocks. As the leading performing sector in 2006, energy has taken one of the sharper tumbles in May, falling 5.7% so far this month.
And what of financials? By far the largest sector in the S&P 500, measured by market cap, financials would seem to be particularly vulnerable at the moment. Indeed, with renewed inflation fears, the threat of still-higher interest rates loom. If history is a guide, that's bad news for companies that thrive on cheap money and robust demand for borrowing.
But if you're expecting clear signs of pain in the financial stocks, you may be disappointed to learn how the red ink has been allocated so far this month. Yes, financials have taken it on the chin in May, descending by nearly 4.3% through yesterday. But that loss, painful as it is, has been exceeded by energy, materials and info tech. In fact, despite this month's sell off, financials are still up by more than 2% on the year.
Meanwhile, BCA Research thinks financials will shine once more. "Inflation fears continue to dominate investor emotions, which suggests more near-term downside in financial stocks," BCA advised yesterday. "However, we eventually expect to step into this weakness, and boost weightings in the capital market group."
BCA's reasoning is that renewed anxiety over inflation will be temporary once the economic slowdown that many expect arrives in earnest. Slower growth equates to a lessening of inflationary pressures, in other words. At that point, a buying opportunity will arrive for financials. "The past few years have shown that after inflation expectations (derived from the TIPS market) have rolled over, capital market stocks soon bottom owing to the inevitable upturn in risk appetites and corporate animal spirits."
Perhaps. But getting from here to there requires crossing what could be some volatile market terrain as investors the world over rethink assumptions about future risk and return. As such, the bulls find themselves on the defensive for the moment. If the current climate proves to be a transition point, increased volatility in the bond and stock markets could be the norm for some time.
The VIX index, a measure of price volatility for the S&P 500 based on options prices, has in fact spiked upward of late, reaching its highest level in more than a year. "The risks are high as the uncertainty around interest rates remains unclear," Herb Kurlan, president of Vtrader Pro, an online trading firm, told Reuters yesterday. "So investors are scrambling to buy puts to lock in any remaining gains they have from the Spring rally."
Optimists point out that sudden, sharp upturns in the VIX have signaled an end to the selling, at least for a time. On the other hand, bottoms in stock slumps are clear only in hindsight, and so the jump in VIX could signal more pain ahead.
For those with a longer-term outlook, the current dip in stock prices may be too enticing to pass up. "One of the main reasons I remain optimistic, despite the recent carnage in global stock markets and commodity markets, is that corporate profits remain extraordinarily strong," writes Ed Yardeni, chief investment strategist at Oak Associates in an email to clients this morning. He reports that forward earnings for stocks across the capitalization spectrum--S&P 500, 400 and 600, or large-, mid- and small-caps, respectively--continue to "soar to new highs" as of May 19. "This suggests," he continues,
that notwithstanding the weakness in housing, the overall economy remains amazingly resilient. The recent sell offs in U.S. stocks was purely a P/E [price-earnings ratio] event. Valuations are even more attractive now, especially given the bullet-proof performance of earnings. Large-cap stocks are cheaper than small-caps, and could outperform as investors seek safety in Blue Chips. However, don't underestimate the power of small-caps to recover smartly from the recent nasty correction based on high-flying earnings. The fact remains that investors around the world have huge sums of money to invest.
Meanwhile, Zacks.com forecasts that the median firm in the S&P 500 will post 10.8% growth this year. That's a slowdown from the first-quarter's 12.8% pace of increase, writes Charles Rotblut for Zacks, noting "many economists have projected a slowing in the rate of economic expansion."
Indeed, the bond market's buying into the slowdown theory these days. The 10-year Treasury's yield has dropped below 5.0% for a time yesterday, the lowest since late-April. So much for inflation fears.
But for all the confidence of what awaits equities, points of transition are inherently tricky and unclear. Some will argue that the bull market in equities remains intact, and that the recent sell off is just a temporary stumble on the road to still-higher prices. But the magnitude of the correction suggests something more than an irrelevant blip. Indeed, equities around the world, in both developed and emerging markets, have stumbled, in many cases sharply.
Yes, higher earnings will almost surely soothe any anxious traders in the coming weeks and months. In fact, higher stock prices from here on out will increasingly depend on earnings growth as an antidote to the fear of the unknown. If the predictions fall short, the retribution could get especially nasty in 2006. Fundamental analysis, as a result, seems headed for a new golden era of influence.
May 22, 2006
A HIGHER PLATEAU
It's passé, out-of-favor, irrelevant, and just plain dull. But its rate of increase has shifted higher. Is anybody watching? Does anybody care?
Not necessarily. Money supply elicits yawns these days. It's been a generation since the days when the release of the latest money supply numbers every Thursday from the Fed attracted widespread attention. Even when the central bank stopped publishing its broadest measure of money supply--the so-called M3 series--a few months back, there was a collective yawn from the financial world.
At the risk of putting readers to sleep, The Capital Spectator nonetheless continues to monitor money supply in the perhaps mistaken belief that something relevant may emerge from the analysis. That includes our belief that maybe, just maybe, there's a link between inflation and money supply.
For those of you still reading, it may be of interest to note that seasonally adjusted M2 money supply (the broadest measure of money supply currently published...last we checked) seems to have acquired a habit this year of consistently growing at a rate above 4%. The last time that happened with any consistency was back in late-2004 and early 2005.
To cite the latest example, in last Thursday's money supply report, M2 advanced by 4.4% over its year-earlier level. Although that's down from the recent peak of 5.0%, it's materially higher than the rate that prevailed in last two months of 2005.
In other words, dear reader, the pace of M2 expansion seems to have found a higher plateau, as the chart below reveals, which shows the rolling 52-week rate of change for seasonally adjusted M2 through May 8. Whether this higher plateau is destined to be long-running, or the start of even greater rates of ascendancy, remain to be seen. But for the moment, there's reason to ponder the implications, the risks, or (for the skeptics) if any of this matters.
May 19, 2006
Inflation returned to the market's collective consciousness this week, as detailed in the April report on consumer prices. But yesterday came more signs that an economic slowdown may in the offing as well, by way of the Conference Board's index of leading indicators and a surge in jobless claims for last week.
Adding to the perception that a downshift in growth is taking root are fresh comments from Fed Chairman Ben Bernanke, who yesterday observed that the real estate market is cooling. "It looks to be a very orderly and moderate kind of cooling at this point," he explained via CNNMoney.com, but a cooling nonetheless.
It's no secret that some dismal scientists have been predicting a softening in the economy's momentum for the second half of this year and beyond. That view has been under pressure of late thanks to a string of economic reports that suggest the economy's still bubbling. But yesterday's numbers give a bit more credence to the forces of pessimism.
If a slowdown is coming, it may arrive just as inflationary pressures are gaining momentum. In that case, does that mean that stagflation is just around the corner?
The seeds of stagflation are excess liquidity conspiring with slower growth. In the worst cases of stagflation, inflation eats away at the value of paper assets while real growth trails the pace of value destruction.
Is stagflation upon us? No, not yet. Keep the fiend at bay will depend on how the Federal Reserve manages the money supply going forward. Make no mistake: finding the sweet spot between promoting growth and minimizing inflation will be difficult, and perhaps impossible. All the usual caveats apply in hoping otherwise, starting with the fact that central banking is a discipline where today's decisions influence outcomes a year or two on.
Long lag times are problematic under the best of times. Unfortunately, these aren't the best of times. In some respects, this particular juncture could scarcely be worse for the prospects of vaccinating the economy against an emerging virus of stagflation while at the same time keeping the economy afloat. The reason is that attacking each side of the stagflation threat requires different and contradictory policies. Alas, both sides of the stagflation threat require attention.
The prescriptions are, at least, clear cut. Fighting inflation is an assault of tightening monetary policy. At some point, squeezing the money supply spurs an economic slowdown or worse. Although robust growth and low inflation have defined much of economic history over the past generation, expecting more of the same as a natural and inevitable outcome may be asking too much of the future.
The Fed, after all, has had its share of struggles in favoring either controlling inflation or promoting growth. It may very well come to that choice in starker terms in the months and years ahead. It wouldn't be the first time. The Fed has faced that Hobson's choice more than a few times over the decades. Unfortunately, history doesn't offer much encouragement that the central bank is always up to the task of balancing this double-edge monetary sword.
On tightening too much and for too long, the infamous example is the early 1930s, when the Fed went off the deep end, with the tragic result known as the Great Depression.
On the opposite extreme is the case of the 1970s, when the Fed unwisely tried to use liquidity to promote growth. The result: high inflation that was only choked off when the fearless Paul Volcker snuffed out the fire in the early 1980s.
To be sure, the modern Fed isn't likely to repeat the mistakes of the past. Bernanke and company is a wise bunch that understands the limits and risks of central banking, in part because they've studied history. As such, any stagflation is likely to be of a milder form compared with decades past.
But intelligence only gets you so far in managing the money supply for the world's largest economy. The challenge is compounded by the fact that expectations for central banking success are sky high. Even a relative stumble by the Fed could trigger profound reactions in the bond and stock markets, i.e., heavy selling.
Monetary policy, we must all remember, is an inexact science. The idea that a cabal of men, sitting in an ornate room in Washington, can dictate the perfect level of interest rates at any given time, and dispense it in regular intervals is the stuff of dreams.
Yes, the Fed has done a masterful job of engineering a lower rate of inflation over the past generation. But how much of that was due to enlightened decisions and how much to disinflationary winds blowing through the global economy?
While we're asking questions, the more pressing one will be: Is the Fed prepared to navigate between the jagged rocks of inflation on one side of the economic channel and the dangers of recession on the other? What are the risks of failure?
For the moment, there are no answers. Bernanke is still an untested steward of the nation's money supply. Meanwhile, monetary policy going forward faces some of its biggest challenges in a generation.
Welcome to a period of transition. It's a long, drawn-out transition, and one with conflicting signals coming on any given day. But no one should ignore the fact that ours is an era of moving from the glories of the past to the hazards of the future. Perhaps the only thing an enlightened investor can do is ask if the various asset classes are accurately priced for the various risks that loom, and then act accordingly.
May 18, 2006
APRIL SHOWERS FERTILIZE INFLATIONARY FLOWERS
When Mr. Market speaks, investors may or may not listen. But when he shouts, almost everyone pays attention.
Mr. Market was definitely shouting yesterday. The S&P 500, every institutional investor's favorite equity benchmark, collapsed on Wednesday, losing nearly 1.7%. That's the biggest one-day percentage retreat in recent memory. The proximate cause was yesterday's April report on consumer prices. Suffice to say, the report was received with less than enthusiasm on Wall Street.
And for good reason. As we wrote yesterday, there's more than enough reason to worry that inflationary pressures are building a head of steam. Until yesterday, there was widespread agreement that the inflation has been "contained," to use one of the Fed's favorite words for communicating recently to the masses that there's everything's under control on the matter of price trends.
Perhaps it's time to rethink that assumption, to judge by the April's CPI numbers. To recap the news that convinced traders to dump stocks and bonds (the 10-year Treasury yield rose to 5.15% yesterday, the highest in four years), the core CPI pace of change jumped to a higher level, running at 0.3% in April, the second month at that level. Meanwhile, top-line CPI is rising at an even faster rate. With both core and top-line CPIs signaling trouble ahead, it's getting easier to favor cash if only because expectations are growing that higher interest rates are still the path of least resistance.
To be sure, it remains to be seen if April proves to be a turning point on the inflation front. There have been scares about pricing pressures before, only to watch the threat evaporate in the optimism of a renewed bull market in stocks and bonds. Will it be different this time? In search of an answer, we took a closer look at yesterday's CPI numbers. If this is in fact the turning point, it's time to acquaint ourselves with the particulars of the transition. As usual, energy was the leading source of upward pricing pressure last month, rising by five times as much compared with consumer prices overall, as the chart below reveals.
For perspective, we also ran the numbers on a trend basis, and once again found energy to be the big weasel in the statistical henhouse of late, as you can see below.
It's all about inflation again, and so it promises to be a long, anxious wait until next month's CPI update confirms or denies April's warning.
May 17, 2006
TRANSITION TIME--THE WEDNESDAY INSTALLMENT
Inflation may not be an overt threat at the moment, but it's too early to stop worrying.
Today's release of the consumer price index for April reminds that the pendulum is precariously balanced and may swing one way or the other in the months ahead. Correctly deciding which way it swings has become the all-important variable that will determine profit and loss for the foreseeable future among the more speculatively inclined players in the capital markets.
CPI's 0.6% rise last month isn't the highest we've seen in recent years, but neither is it the lowest. In fact, April's advance, when put in context with recent history, exhibits many of the qualities that one associates with persistence. Stubborn upward persistence, we might add, noting that prices seem inclined to rise rather than play dead.
The trend is obvious when one looks at a chart of monthly 12-month CPI percentage change over time. Indeed, consumer prices are pushing higher over time. The trend unfolds in fits and starts, but it's a trend nonetheless.
Even the so-called core rate of CPI, which excludes food and energy, appears to be percolating higher. For the second straight month through April, core CPI is running at 0.3% a month, a clear step up from recent history. This is especially worrisome since the formerly quiescent core CPI has been the fountain of optimism from which inflation doves have been drinking. If this gives way, a broader rethinking of inflation expectations may be coming.
If so, the Federal Reserve will have no choice but to continue nipping pricing pressure in the bud, an effort that of course means interest rates will rise further. The bond market seems to understand the risk at the moment, even if it proves to be hollow down the road. There are no shortage of pundits advising that the economy will slow in the coming months and in 2007, in which case inflation's upward momentum may prove to be short lived.
But today, the fixed-income set is reading the trend lines on the wall at the moment and deciding that caution trumps heroism in the bond pits. As we write this morning, the 10-year Treasury yield is 5.16%, which is to say it's bumping up against its highest level in four years. Meanwhile, over in Fed funds futures trading, there's a growing suspicion that more rate hikes are coming as the year unfolds.
The celebrations of the recent past, born of the belief that the Fed would pause with rate hikes, are giving way to the sober reality imposed by the data. Indeed, the Fed has counseled the markets to price securities to do no less, having advised in its May 10 FOMC statement that "further policy firming may yet be needed" depending "on the evolution of the economic outlook."
The economic outlook is in fact evolving, and perhaps faster than some expected. Or so today's higher-than-expected April CPI implies. "The risks of a June Fed hike are higher, although we still have to see May's CPI and plenty of activity data between now and the next Federal Open Market Committee meeting," David Sloan, an economist at 4CAST Ltd., opines in an interview with Reuters today.
It's all about the data now.
May 16, 2006
STYLE ANALYSIS, AND ONE MAN'S QUEST TO BUILD BETTER INDICES
Ron Surz of PPCA Inc. says he's built a better mousetrap of indices used for benchmarking and analyzing money managers. In fact, he's just following the advice of a Nobel Laureate.
Professor William Sharpe, who shared a Nobel Prize in 1990 for his work on developing the Capital Asset Pricing Model, laid out the foundation for returns-based style analysis in a 1992 paper. The strategy is one of analyzing, say, a mutual fund's returns by regressing performance against various indexes to determine what's driving the performance. In essence, it's a quick and fairly reliable way of x-raying a portfolio to see what's going on behind the scenes.
For example, by running a returns-based style analysis on an actively managed large-cap U.S. stock fund, one might learn that the benchmark-beating results came primarily from loading up in small-cap companies. There's nothing wrong with that, of course. But if you're telling the world that your benchmark is large-cap stocks, you'll have some confused (or angry) investors if they learn that you're buying small-cap equities. Perhaps, then, a small-cap index is the better benchmark for the fund, in which case maybe the large-cap manager's performance doesn't look so impressive after all.
So it goes in the world of analyzing managers. Trying to make apples-to-apples comparisons is the bane of analysts who are forever attempting to separate alpha's wheat from beta's chaff. No easy task in the best of times. Talent, after all, isn't easily defined, and less-than-obvious when looking only at numbers. Indeed, surveying past performance offers no foolproof way for deciding that manager A has the right stuff and manager B is a pretender to the throne. That's not to say that reviewing the past is worthless. But there are limits to studying history as a short-cut to seeing the future.
That said, some argue that an effective search for talent requires going through a portfolio's holdings with a fine tooth comb, and comparing changes over time. But a holdings-based analysis isn't practical because managers' reports are infrequent, and quite often out of date. In the case of some hedge funds, you might not ever learn what it's in the portfolio. So much for timely analysis.
No wonder, then, that returns-based style analysis has proven so popular. Manager participation not required.
Indeed, since Sharpe's paper was published in the Journal of Portfolio Management in 1992, the world has embraced his technique. The reason: it provides a degree of transparency for manager evaluations that's otherwise impractical. What's more, returns-based style analysis is relatively easy to run, especially when it comes to mutual funds. With index returns in hand, you can analyze any fund simply by comparing its returns with various benchmarks over time. And since mutual fund returns are updated daily, the timeliness factor is satisfied. Some are applying returns-based analysis to hedge funds as well.
Predictably, a variety of software products catering to returns-based analysis are available, including Zephyr StyleAdvisor and Ibbotson Associates' EnCorr Attribution, to name but a few. Sharpe's theory, in short, has long been transformed into practical application.
But style analysis isn't quite what it could be, charges Surz, president of PPCA, an investment consultancy that designs its own suite of portfolio evaluation tools and indices. The critical issue is choosing the right indices, says Surz, who holds an MBA in Finance and an MS in Applied Mathematics. In other words, satisfying Sharpe's call for mutually exclusive and exhaustive indices is critical, and not every index shines by this standard. That's one reason why he came up with his own benchmarks, which are available gratis at PPCA.
By comparison, the usual choices from the big boys leave something to be desired, Surz opines. "If you read Bill's article, you'll see that he lays out clearly how the so-called style palette ought to be constructed. The operative rules [for the indices] are mutually exclusive and exhaustive."
Surz goes on to explain that there's a "strong statistical reason" for that. "If they're not mutually exclusive, it creates a problem called multi-colinearity." In other words, even though you're using two indices measure value and growth stocks, there's some overlap in what they're measuring and so some stocks show up in both indices. In which case, the information that returns-based style analysis is telling you may be of a lesser quality, if not entirely misleading, than it otherwise could be with better-designed indices.
One example: if IBM is labeled (or mislabeled) as a growth stock and a value stock at the same time, it shows up in a value and a growth index. That's a problem, and it does in fact happen, Surz warns. The solution: don't use indices that double count. But if you're using the growth and value indices for the Russell 3000 indices, Surz says, there's overlap of roughly one-third, measured by number of securities as well as by dollar value. "So a third of the companies are in both value and growth indices. That means that you have the statistical problem of mutli-colinearity if you use the Russell indexes in your style analysis."
As a result, you'll get "erroneous style profiles because those indices don't meet the criteria set out by the guy who developed the idea," he continues. "That's like writing down instructions to build the world's best car, and then you decide you want to substitute a different carburetor. The car's not going to run right. In fact, it's not going to run the way it was designed to run."
The good news is that the major index vendors are aware of the problem. Indeed, there have been some efforts of late to fix the glitch. The bad news: progress is spotty, and in some cases still nonexistent.
The new style indices from Standard & Poor's solve part of the problem, Surz admits. The new style indices replace the old S&P/Barra style benchmarks, which died a quiet death last December. But progress isn't perfect. In particular, the mutually exclusive problem is resolved, but the solution comes at the expense of introducing other challenges. "If you were to just use the Pure Style indices, you'd be well served in the mutually exclusive area," he explains. "But you won't meet the exhaustive criteria because the Pure indices throw out the stuff in the middle."
The "stuff in the middle" is purposely cut out of the new style indices from S&P. And since S&P doesn't offer a core index, this slice of the equity market is lost as it relates to the new style indices.
"The stuff in the middle is important," counsels Surz. "In my opinion, it's like taking the Oreo cookie and throwing out the middle." In effect, he asserts that the core should be treated as a distinct asset class, and made available for returns-based style analysis.
The reason is that value and growth stocks have a history of low correlation--i.e., one is usually in favor while the other languishes. The Russell 3000 Value, for instance, posts a 7.4% annualized return for the five years through yesterday. The Russell 3000 Growth, on the other hand, suffers a small annualized loss over those five years: -0.3% a year.
But while value and growth stocks are often on opposite sides of the performance spectrum, core isn't always in the middle. At least not all the time, Surz warns. Core, he says, often behaves differently than either value or growth, and so ignoring core can introduce a number of risks when analyzing returns. For example, he points out that in 2005's second quarter, core stocks fell by 0.2%, according to his calculations. Meanwhile, value and growth stocks each were up by more than 2% during that span. Overall, about one-third of the time core stocks go their own way, and so ignoring them in returns-based style analysis could deliver misleading results.
But there's a better way to analyze returns, and Surz says he has the answer: build better indices. He's done just that. His large-, mid- and small-cap indices are at once mutually exclusive when it comes to the value and growth benchmarks, and exhaustive by including all stocks by way of a core indices. "I don't throw out any companies," he boasts.
Surz offers the underlying data for both domestic and international indices, and at no charge. You can download the numbers at his site.
To be sure, Russell, S&P and the other major index vendors aren't exactly worried. Surz is a tiny fish in a big pond when it comes to the equity index business. Nonetheless, there are alternatives to the big boys, and arguably superior alternatives.
But when it comes to the old saw that the world will beat a path to your door if you build a better mousetrap, well, that's still an open question.
May 15, 2006
THE PRICE OF RISK
Sometimes a picture really is worth a thousand words. Whether it's also a window into the future is an open debate. With that in mind, we'll simply post a chart of last week's returns for various asset classes. Take note that the high-flying returns that risk has so generously dispensed of late has reversed course. Risk does indeed pay off handsomely at times, particularly over the long haul. But there can be a price to pay for touching the sky in the short term. The question is, how big a price?
Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), DJ REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($)
May 12, 2006
A GOLD BUG'S GOLD BUG SPEAKS
It's yellow, it's malleable and its price is soaring.
An ounce of Gold yesterday moved above $725. That's up about 40% so far this year, and double the price from about three years ago. The precious metal, in short, is enjoying its greatest bull market in a quarter century.
The general assumption for the ascent is that inflation fears are stoking demand for the metal. Gold, after all, has a long history of proving itself as an inflation hedge, and a few thousand years of pricing aren't easily dismissed. But one fiercely independent gold bug says there are other forces pushing the price of gold upward. In particular, gold's price has taken wing because of the unwinding of the so-called gold cartel, which rigged the price of gold over the past ten years. This according to Bill Murphy, a former commodities trader who's now chairman of the Gold Anti-Trust Action Committee (GATA).
Murphy and GATA have been called extremists, even by other gold bugs. Indeed, GATA spins a heavy tale of a government and Wall Street conspiracy, charging that the Federal Reserve and powerful banks have been manipulating gold for years, keeping its price lower than it otherwise would be. This is strong stuff, and even some card-carrying gold bugs are inclined to distance themselves from the theory. Euro Pacific's Peter Schiff, for instance, yesterday told The Wall Street Journal (subscription required) that GATA is "a little conspiratorial, for me even. I don't know if there was any real orchestrated event."
Nonetheless, the fact that the Journal is writing about GATA and its theories suggests the world is coming around to taking Murphy's conspiracy talk seriously. Or so says GATA's chairman in the following interview. Another example he cites of the rising respect for GATA's message: a gold report published in January by European bank Cheuvreux that references GATA's research.
The Capital Spectator talked with Murphy yesterday by phone to learn more. With gold prices soaring, the time is ripe for a chat with a gold bug's gold bug. Indeed, Murphy thinks a run in the metal to as much as $3,000 or more isn't beyond the pale.
In any case, we can't confirm or deny Murphy's assertions, but given the strength in gold prices of late we're not ruling anything out at this point.
WHAT'S DRIVING THE GOLD BULL MARKET THESE DAYS?
There's a short squeeze of epic proportions going on.
The gold cartel--the United States government, some other central banks and the bullion banks like Goldman Sachs and J.P. Morgan Chase--rigged the price of gold in the mid-1990s. It started with [former Treasury Secretary] Robert Rubin and the strong dollar policy. To help rig the price, in clandestine fashion, [several large banks] borrowed gold from the central bank and leased it into the marketplace without telling anybody--this was the gold cartel.
What happened was that the bullion banks could borrow gold at, say, 3/4% to 1% from a central bank, and then they would sell it. And that sold [shorted] supply would keep the price down. They would invest the proceeds [elsewhere], and for years they were trading in a rigged market, which allowed them to make money [at the expense] of the speculators who were unaware of what was going on.
HOW MUCH GOLD ARE WE TALKING ABOUT?
Most people say the central banks have 32,000 tons of gold. GATA figured out that they have less than half of that--around 16,000 tons. It's no longer in their vaults. This gold, a lot of it, has been loaned out, and it eventually has to be paid back, at least paid back in cash or something equivalent in value. But you now have a gold market with a 1,500 ton-per-year supply deficit. New mine supply's only 125 tons a year, and that's going down. So the gold cartel's short, say, 16,000 tons of gold. How do you cover that when there's already a 1,500-ton-a-year deficit?
HOW DID THE BULLION BANKS ORIGINALLY GET SUCH A GREAT DEAL WITH THE CENTRAL BANKS?
They're big bullion dealers. They're also ring leaders of what I call the gold cartel. At Goldman Sachs, for example, you had Rubin, who was very close to the government [when he left Wall Street to become Treasury Secretary in the Clinton administration]. Meanwhile, J.P. Morgan Chase is probably the United States' major bank.
WHAT WAS THE INCENTIVE BEHIND ALL OF THIS RIGGING OF THE GOLD MARKET?
They made a fortune; made billions. They had free money for all those years. And because they knew the price wasn't going to go up, they could trade against the speculators [by shorting gold]. The speculators would buy, and the bullion banks would get short, and they'd flush out the speculators. The banks knew [that gold's price] wasn't going to go up. And whenever it went up temporarily, they sold more. But now the gold cartel's hit the wall.
They don't have the central bank gold [to short] anymore because it's gone. The banks that still own some want to keep it.
WHY ISN'T THE REMAIN CENTAL BANK GOLD AVAILABLE TO SHORT?
It just ran out. They hit the wall. It was fashionable for to sell gold years ago. Now, [the central banks] are terrified to announce they've sold gold. Plus, the European Central Bank has announced that they will sell no more gold this year. So has the Bundesbank. The gold cartel is screwed.
The whole thing was outlined at the GATA Africa Gold Summit in Durban, South Africa on May 10, 2001. The price back then was about $258. We predicted [the bull market in gold]. It was also laid out at Gold Rush 21, our second conference on August 8 and 9, 2005, when gold price was $436 an ounce. We had the most brilliant guys I've ever met as speakers. But most importantly, we had Andrey Bykov, economic consultant to Putin, Russia's president. The speakers all laid out what was going to happen and why. Bykov said it was the best conference he was ever at. He went back [to Russia] and gold's price has gone up since. [For some perspective, take a look at a story in the British press from last November on the subject of gold purchases by Russia's central bank.]
WHAT'S THE CONNECTION BETWEEN BYKOV AND GOLD?
The Russians left our conference and started buying gold two days later, when the price was $436. In addition to the Russians buying, the Chinese have been buying--I know that for a fact. And I learned today that Iran is buying all the gold they can get their hands on. It all stems from what happened at Gold Rush 21. Word got out. The Russians learned about the short positions of the gold cartel. They sent Bykov there to make sure we were correct. I'm going to send you a link by email to help you tie it all together. The Bank of Russia talked about GATA a year earlier at a big bullion dealer meeting. They cited our work. They've been following us for a long time.
Once Bykov left, the gold world changed for ever. In essence, [the Russians] realized the price of gold was going to explode, and it would probably do so soon. They also realized they could probably squeeze the gold market, and take advantage of the people who have to cover their shorts. How long can you stay short? They're getting killed.
I'm going to send you a link to a report from a European investment firm, Cheuvreux,--a 56-page report that said GATA's correct about the rigging of the gold market, and that the gold price was going to explode. That report's going to the biggest money [investors] in the world.
WHAT SHOULD PEOPLE UNDERSTAND ABOUT THE GOLD MARKET GOING FORWARD?
They should understand that this move is for real, and it's only the beginning. We're probably going to see $3,000 to $5,000 an ounce. Also, most people don't understand what GATA knows, because we were blackballed from the U.S. mainstream press until this past week [the Wall Street Journal quoted Murphy in a story (subscription required) yesterday.] The biggest money--the Russians, the Chinese, the Iranians, the tycoons--they know that GATA's correct.
YOUR BASIC MESSAGE IS THAT THE GOLD MARKET'S HAS BEEN MANIPULATED BY CENTRAL BANKS, BUT NOW IT'S COMING BACK TO BITE THE CARTEL.
Right. Now they've lost control.
THIS IS THE FLIP SIDE OF THE PREVIOUS MANIPULATION?
Exactly. It's like Newton's law: for every action there's an equal and opposite reaction. That's what's happening, and the gold cartel can't get out--they're trapped. They're trying to get out--they're buying every day. I'm not guessing on this either. Gold has rallied, but the open interest for gold futures contracts on NYMEX hasn't changed--it's not going up.
WHAT DOES THAT SIGNIFY?
That this isn't a speculative move higher. I used to be a limit position trader, so I know what I'm talking about. In a speculative move, the speculators come in, and there's all this excitement, and everyone gets bullish, and then the market tanks and the specs get washed out. It's not happening this time. The open interest is staying flat. This is almost unprecedented in that there's a strong upward move in prices and the open interest doesn't go up. The reason is because the gold cartel is getting out as possible [from the short positions]. They've been exiting the market now for months because they're getting killed.
WHATEVER THE REASON BEHIND THE GOLD BULL MARKET, THIS REFLECTS POORLY ON THE FEDERAL RESERVE AND THE DOLLAR, RIGHT?
What happens normally every time gold goes up? What do you hear people say? Inflation, prices. It's always bad for what I call planet Wall Street and the U.S. government. In 1988, Larry Summers [a former Treasury Secretary], when he was a professor at Harvard, wrote a paper about Gibson's Paradox and the gold standard. He said there was a relationship between gold and interest rates. If you could keep the gold price low, you could keep interest rates low--that's basically what he said in the paper. What Robert Rubin did [when he was Treasury Secretary] was make rig the gold price for the strong dollar policy. The government wanted to keep interest rates lower than they would have been, to disguise the inflation going on behind the scenes in the U.S., and to keep money coming in to the stock market, and to keep confidence high in the dollar.
May 11, 2006
IN PAUSE WE TRUST
If the Federal Reserve's announcement yesterday on interest rates was intended to keep the market guessing, the central bank scored a home run.
The bond market went exactly nowhere yesterday, although at various points the fixed-income set was alternatively bullish and bearish. But when the dust cleared, the 10-year yield was unchanged at 5.125% at Wednesday's close.
In fact, shrugging one's shoulders is an eminently reasonable reaction to yesterday's Fed advisory. The rhetorical smoking gun from the FOMC is this line: "The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information."
That's a slight change from the previous statement in March, which said that "some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance."
Translated: a pause in rate hikes is all but assured when the FOMC meets next in late June. That implies that Fed funds rate is at or near the typically elusive state of monetary affairs known as neutrality. In Goldilocks fashion, a neutral Fed funds is neither too hot nor too cold, or so we're told. Occupying this never-never land is said to neither promote growth nor retard it. Bernanke and company seem to be saying that we've now reached this state, and so further rate hikes are unnecessary, and perhaps even detrimental.
But there are no free lunches, even in the land of neutrality, which is fostering a bit more indecision than usual about what comes next, according to Ken Kim. An economist who watches the central bank for Stone & McCarthy Research Associates, Kim tells CS that decisions are getting trickier for the central bank:
Now that the Fed's closer to the perceived neutral rate, unfortunately there is more uncertainty as to where the stopping point is [for rate hikes]. Even though they have models and forecasts, it's hard to specify within a quarter percent of where you should be. I think we are at neutral. My personal opinion is that come late June, at the next FOMC meeting, they're going to pause and leave the Fed funds rate at 5.0%.
We also called David Resler, chief economist at Nomura Securities in New York. He thinks Fed funds are slightly above a neutral rate, but "not so far above it to create a serious risk to the economy."
In any case, Resler too expects a pause at the next FOMC meeting. In fact, he thinks the pause could last for a spell. He tells CS that there were three pauses lasting more than 12 months during Greenspan's tenure, and so it wouldn't be out of the ordinary to witness the Fed sitting on its monetary hands beyond the June meeting. Resler goes as far as to say that the next time the Fed changes interest rates from the current 5.0%, it will be one of lowering Fed funds.
"It is my belief that the Fed should stop tightening," Resler says. In support of that counsel, he points to the softening in employment data and housing numbers, which are "painting a very consistent picture of slowing demand." Although some pundits take issue with the outlook that the economy's winding down a notch, the Fed is nonetheless worried that growth will moderate. Keeping the expected moderation from something worse has become job one for the central bank.
The luxury of focusing on keeping growth intact, albeit at a slower pace compared to recent history, is dependent largely on the view that inflation isn't a material threat. What about the surge in energy prices? If higher energy prices were going to push up core inflation rates, we'd have seen it by now, Resler reasons. But there's no smoking gun, which is giving the Fed a green light to increasingly focus on managing economic growth and pull back a bit on nipping any future inflation in the bud.
The weeks ahead, leading up to the next FOMC on June 28 and 29, will either confirm or deny the wisdom embedded decision. For the moment, though, the inflation hawks are on the defensive. All that's left to do is take the Fed's advice and watch the date…closely.
May 10, 2006
ONE MORE HIKE?
The Federal Reserve's FOMC meets today, and it's widely expected that interest rates will again rise by 25 basis points, bringing Fed funds to 5.0%. That's a prediction hardly worth the name, as the Fed's been dispensing 25-basis-point hikes methodically since June 2004. Indeed, the Fed funds futures contract for May is priced for 5.0%, and hardly anybody expects a surprise.
What's different this time around is that Fed Chairman Bernanke has recently suggested that a pause in rate hikes may be coming. But given the ensuing debate that Bernanke's advisory triggered on the matter of his inflation-fighting credentials, some wonder if perhaps Ben may rethink his inclination to put tightening on a hiatus, temporary or otherwise.
A bit of uncertainty, in short, hangs over the policy outlook for the Fed for the first time in recent memory. Perhaps it's unavoidable, given the ample dose of conflicting signals coming from the economy and the capital markets on the all-important question of whether GDP is or isn't slowing more than a little. But no matter the cause, transparency has dropped down a notch or two for the Fed. For the moment, the central-bank transparency that Bernanke has long espoused as an academic looks to be on the defensive now that he's running the money machine in Washington. That may change in the future, but in the here and now there's a bull market in guessing where monetary policy's headed, and that's probably not what the Fed wants.
Or is it? Bernanke himself confessed in March that "the implications for monetary policy of the recent behavior of long-term yields are not at all clear-cut." No one can accuse him of exaggerating, considering the current state of puzzlement over the future of Fed policy.
If anxiety is the obvious reaction to a central bank that seems to be struggling with what to do next you wouldn't know it by looking at the stock market. The S&P 500 has climbed by 2.4% in the last four weeks and is up a tidy 6.8% so far this year, through yesterday's close. Meanwhile, small cap stocks continue to deliver even better gains. The Morningstar Small Cap Index is up 3.5% in the past four weeks, and year-to-date it's increased by 15.9%. If this keeps up, Bernanke's rhetorical ramblings will deliver one heck of a bull run by Christmas.
In fact, it's the bond market that's showing increasing signs of worry. The Lehman Brothers Aggregate Bond Index is flat for the past four weeks, and down by 1% for the year so far. Although the recent run-up in the 10-year Treasury yield has slowed this week, it's still holding above 5.1%, and in fact looks set to keep rising in the coming weeks and months, to judge by the momentum displayed of late.
Meanwhile, Bernanke is being warned by the gold market that business as usual isn't acceptable, to judge by the Fed chairman's recent manner of discussion. Gold touched $700 an ounce for the first time since the Jurassic period. That translates into a 35% rise so far this year for the precious metal. It's getting harder for the Fed to shrug off this barometer, which is first and foremost a reflection on the growing doubts about the dollar as a store of value. Does this mean the Fed will feel compelled to dump some of its massive gold holdings on the market to trim the metal's rise, if only temporary?
To be sure, some of gold's run comes from various geopolitical jitters, starting with the ongoing quarrel with Iran and the West over the former's nuclear ambitions. Such tensions, along with the usual worries over America's trade and budget deficits, are conspiring to drive down the dollar to depths not seen since May of 2005. If nothing else, the dollar's plunge lends legitimacy to gold's rise.
The stock market may be unconcerned with all this, but there's a decent chance that the nail-biting that's descended on the fixed-income set will migrate over to equities in the near future. But first Mr. Market will take a look at the FOMC statement scheduled for publication this afternoon. Rest assured that traders and economists the world over will be giving the statement a razor-sharp scrutiny in search of clues about what the Fed's thinking for the future. It promises to be wasted energy. The central bank is making it up as it goes along at the moment.
There's a lot of tension in the air, and deconstructing Fed statements is no cure for what ails. When the stock market throws in the towel, then the fun will really begin.
May 9, 2006
OPTIMISM RUN AMUCK?
The Saudis are optimistic. Really optimistic. Ali al-Naimi, minister of petroleum and mineral resources for Saudi Arabia, said last week that "there are at least 14 trillion barrels of reserves in the world," according to a transcript of a conference hosted by the Center for Strategic & International Studies in Washington. How much is 14 trillion barrels of reserves? Three-and-a-half times more than the highest estimate noted in an historical survey of such guesses by other, as published by 2000 study the Energy Information Administration.
Meanwhile, a new article published by the Reason Foundation references an estimate from the industry journal World Oil, which cites proven oil reserves—defined as oil that is recoverable presently given current economic and business conditions—is 1.1 trillion barrels. BP puts the number at 1.2 trillion, and the Oil and Gas Journal says 1.3 trillion. Last year, the Reason article continues, the IHS Energy consultancy "estimated that the world’s remaining recoverable reserves, excluding unconventional sources such as heavy oil or tar sands, are between 1.3 trillion and 2.4 trillion barrels."
If there's one thing that unites the otherwise disparate conjectures about how much oil's left, it's the fact that all are lower than Minister Ali al-Naimi's estimate. Perhaps there's some play in the difference when it comes to comparing estimates of "recoverable" reserves vs. total remaining reserves otherwise uneconomical. But the minister's optimism suggests that something close to his belief in the 14-trillion-barrel number is approachable, courtesy of technology. "With advance[s] in technology, I believe our ability to recover more of the 14 trillion is there," he said at the CSIS conference.
The stakes, of course, are high when it comes to the debate about how much oil is left. The center of the universe for this debate is Saudi Arabia itself, which is the globe's leading producer of oil and home to the biggest reserves in any one country. Matthew Simmons, chairman and CEO of Simmons & Co., launched a fierce discussion over Saudi reserves last year with his 2005 book Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, which questioned the outlook for raising Saudi Arabia's future oil production.
But the Kingdom remains optimistic on that front too. "We [in Saudi Arabia] are undertaking a massive investment program to increase our production capacity to 12.5 million barrels per day by 2009 with the potential for more later if market conditions warrant," the minister promised at the CSIS confab. "This expansion will make a significant contribution to meeting the world's increasing needs for energy." If it comes, it would represent a roughly 14% increase over current Saudi production as of March, according to EIA.
Greed and fear may rule in the pricing of oil, but when it comes to official Saudi estimates of black gold, the coin of the realm is optimism. The question is whether that optimism is on steroids.
May 8, 2006
TIMING & MAGNITUDE
It was the best of times, it was the worst of times, Dickens wrote in A Tale of Two Cities. One might say the same after surveying the outlook for the economy and the implications for investing.
There are numerous straws about that threaten to break the proverbial camel's back. At the same time, there are a number of counter forces at work that may bushwhack the best- laid expectations of the pessimists for a time. Watching this back and forth, and trying to figure out when and where a tipping point will occur represents one of the more worthwhile areas of scrutiny for the intrepid investor.
On the aisle of optimism is the bullish prediction flowing from the most famous discounting mechanism, otherwise known as the stock market. Equity traders, bless their little hearts, just can't help bursting with bullishness these days. Friday's session was particularly exuberant, with the S&P 500 surging upward to its highest since early 2001. Indeed, the 1% climb on May 5 was anything but tentative. The stock market is hardly infallible. But if the steady climb in equity prices that's prevailed for much of the past two years is misguided, it's one of the more consistent and lengthy instances of imprudence on record.
Jumping on the bandwagon of optimism is European Central Bank President Jean- Claude Trichet, who says that "global economic growth remains strong and steady," Bloomberg News reports.
There are, of course, counter arguments to that sunny disposition, as long-time CS readers can attest. But for investors interested in making money, dissecting the potential for risk and reward demands a judicious, objective summary of the full scale of what appears to be unfolding. So, yes, the list of encouraging reports favoring the vision of economic growth is plentiful of late, as we've documented over the past weeks and months. Meanwhile, the presence of positives doesn't banish the existence of negatives, of which there is no shortage either. The forecasting challenge is figuring out how the two sides of light and dark interact.
The global economy, after all, is the most dynamic it's been in generations, perhaps in all of history. Money flows effortlessly across borders of the leading economies, and something approaching free-market prices impact the value of goods and services and consumer decisions, governments, central banks and corporations. As a result, there is a constant feedback loop in place, a process that's at once reactive and anticipatory.
Recognizing as much, one might wonder how the system will adjust in the coming weeks and months to what is arguably the primary threat to global growth, at least among the threats that we can see and prepare for (or dismiss) in the here and now. Oil prices, in other words, remain high, and stubbornly so.
Over the past two years, the price of a barrel of oil has roughly doubled, having closed at around $70 in New York trading last week. To date, the price ascent has come with relatively little fallout for the general economy, at least relative to what some might expect after studying the history of oil bull markets. Some say it's different this time because the higher prices have come from rising demand rather than an artificial cutoff in supply. True, although eventually high oil prices are still high oil prices, and the laws of economics will prevail. As such, everyone has to ask themselves if the effects of high energy costs are any different in a supply-driven bull market vs. a demand-driven one.
In any case, while the global economy has weathered the bull market in energy so far, it would be foolish to think that the danger has passed. In fact, the dynamism of the economy is reacting as we speak, just not in sharp, obvious ways in the short term. Rather, the change is evolutionary and slow, but decisive nonetheless.
We could easily provide a laundry list of global economic shifts born of oil's price rise that represent change in some material way, if not today then tomorrow. The question is, as always, timing and magnitude.
In any case, you may have noticed that oil-exporting nations are accumulating huge cash reserves that were formerly the stuff of dreams for many of these nations. The Economist reports that oil exporters' current-account surpluses grew to $400 billion in 2005, up by four times from 2002 and on track to rise to $480 billion this year.
Piles of cash, of course, represent power, and power brings change. A quick example on the geopolitical front: Venezuela's oil exports are funding the dreams and visions of socialism, as conceived by Hugo Chavez. Take note that Chavez has made it clear that he intends to do all he can to offer aid and comfort for energy exporters elsewhere in their efforts to nationalize energy operations and otherwise thwart the free market pricing system that's built up over the years. The beneficiary du jour is Bolivia, which is moving ahead with nationalizing one of South America's most strategic reserves of natural gas exports, in part thanks to pledges of funding from Venezuela.
Then there's the issue of what kind of purely economic adjustments will come from high oil prices. Expecting the status quo to dominate is foolish. Although it's hard to say exactly what's coming, we can throw out some informed guesses, starting with higher inflation, if only marginally so. No sign of that yet, but even a small uptick from current levels could send shivers down the equity market's spine, in part because stock prices have enjoyed such a potent run in recent years, and at a time when inflation has remained relatively quiet. If inflation were to prove itself viable at maintaining a 3-4% rate in the United States, the reaction from the Fed and the stock market would be less than subtle.
Meanwhile, it's also prudent to expect that higher energy prices will squeeze consumer spending. There may be scant signs of fallout from this process so far, but there's also a lagged effect from energy price shocks. That realization, combined with the slow but steady hikes in interest rates, will eventually conspire by delivering something less than edible for the equity market's current appetite for risk. Again, timing and magnitude are the open questions.
We can also point to the dollar to project hopes and fears, depending on one's bias. The buck is currently suffering its sharpest stumble in recent memory. The U.S. Dollar Index is at its lowest in about a year. Arguably, some (most?) of this is the adjustment from America's massive and growing imports of higher-priced oil. A lower dollar raises the price of imports, including oil. Yet, in theory, this may help reduce America's trade deficit, because higher-priced imports may eventually lessen consumer spending while promoting U.S. exports via lower prices when measured in foreign currencies.
But a falling dollar also has risks. If it falls too far, too fast, foreigners may be increasingly reluctant to funnel money into America, which has become dependent on such flows in recent years. Then again, slowing inflows imply higher interest rates if demand for bonds weakens via a conspicious absence of foreign buyers. Higher interest rates, meanwhile, may boost the dollar in forex markets.
The potential for a virtuous circle is always just around the corner. Timing and magnitude, Virginia, timing and magnitude.
May 5, 2006
The train kept a-rollin', all night long,
With a heave, and a ho,
Well I just couldn't let her go.
Risk, we're so often told, reaps reward. If there are exceptions to this rule from time to time (and there are) it's less than crystal these days.
As the chart below reveals, risk across the board has paid off handsomely in the recent past. As a snapshot of the past, this is a reason to celebrate, at least for those who've been long in certain asset classes. But the chart also represents a challenge, namely, where to deploy money now? Does this chart draw the profile of bull markets still in their prime? Or does the layout of the returns give you pause?
Emerging markets stocks, the riskiest of the asset classes in our survey, is the clear leader so far this year and for the past three years as well. In fact, equities generally, and a broad mix of commodities, occupy the top half of the performance roster, while the lagging returns are populated exclusively by bonds of various kinds, the so-called safer investment species. The pattern is true for both year-to-date and trailing 36-month returns through May 2.
Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), MSCI REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, 3-mo T-bill, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($), Vanguard Infl Prot Sec
The dollar-based advance in emerging markets stocks is especially hot. The MSCI Emerging Markets equity benchmark has soared by annualized 42% a year after translating the gains back into greenbacks. By any standard for asset classes, American investors have been treated to a level of profits rarely witnessed in so short a period. Even the red-hot commodities sector overall hasn't kept pace with the stocks of emerging markets from a dollar-based perspective.
The ascending state of equity prices in developing markets may be eye-popping, but is it speculative? Not necessarily. As the IMF noted in its World Economic Outlook published this month, "Growth in most emerging and developing countries
remains solid, with the buoyancy of activity in China, India, and Russia…being particularly striking."
And the good times are expected to keep rolling along, or so GDP predictions imply. On a relative and absolute basis, forecasts for real GDP growth for emerging markets are impressive, not to mention well above those for developed nations as a whole. The "emerging Asia" countries, for instance, are expected to deliver real GDP growth of 7.9% and 7.6% this year and next, respectively, the IMF reports. Meanwhile, "emerging Europe" is looking good too with an expected real GDP rise of 5.3% for this year and 4.8% in 2007. Even the ailing Africa is thought to be on track to muster real GDP growth of 5.7% this year and 5.5% next year.
The developed economies too will keep growing, although the outlook generally pales by comparison with emerging markets. In fact, a growing number of forecasters expect the great engine of global growth of recent years--the U.S.-- to falter, if only slightly later this year and on into next. As Northern Trust's Paul Kasriel explained yesterday in an interview with CS, the United States is on track for decelerating growth.
If so, the question becomes: what fallout, if any, will an American slowdown have on emerging markets? The United States has been sucking in imports in ever greater quantities, and in the process sending vast quantities of dollars abroad. The trend has benefited emerging markets in no small degree. China, to cite the obvious example, now sits on dollar reserves that are the world's second largest, a testament to the economic opportunity that's come by way of U.S. growth. Does the process work in reverse if American GDP decelerates? If so, what does that imply for equities in those otherwise sizzling emerging markets?
Such worries are of no concern at the moment to investors in the stocks of developing countries. The bull market train just keeps rolling. In just the past four weeks, for instance, the MSCI Emerging Markets index has jumped over 7%. v. 0.9% for the S&P 500. Relative outperformance rarely looked so sexy.
But every bull market has its limits, in part because every bull markets sows the seeds of its own demise. Timing, of course, everything. It may be later than you think.
May 4, 2006
IS A PAUSE PRUDENT AT THIS JUNCTURE?
There's a growing chorus of predictions that the economy's due to slow later this year. But recent economic reports don't yet jibe with that view. Could the forecasters be wrong? Or just early?
Nonetheless, the Federal Reserve expects the economy will cool, if only slightly. Thus, Fed Chairman Ben Bernanke's announcement last week that the central bank is considering a pause in the current round of interest-rate hikes.
The Fed wants to avoid a recession. But does pausing with monetary tightening come at the price of letting inflation gain a stronger foothold in the economy?
For some thoughts on that and related questions, we called Paul Kasriel, director of economic research at Northern Trust. In a telephone conversation yesterday, Kasriel expounded on why he too thinks the economy will moderate.
WHAT'S YOUR TAKE ON FED POLICY THESE DAYS?
The Fed's following a restrictive monetary policy. Not necessarily a recessionary restrictive monetary policy. But I think the Fed has already put in place a monetary restriction so that we'll see a lower trend in economic growth. The year-over-year growth in the first quarter was 3.5%, and I think we'll trend lower than that as we go through the year.
WHAT EVIDENCE DO YOU SEE IN SUPPORT OF YOUR OUTLOOK?
There's a lot of evidence in the leading indicators.
I guess I'm one of the last people to still pay attention to the money supply, and we've seen a significant slowdown in the price-adjusted or real M2 money supply.
And although we've seen some widening in the spread between the 10-year Treasury and the Fed funds rate, that spread on a longer-term basis has come down quite dramatically.
Meanwhile, housing has been a leading sector of the economy as a whole. If you look at things on a year-over-year basis, we've seen a definite slowdown in housing activity. Both new and existing home sales have slowed. And [house] prices are softening.
Then there are automobile sales, although I haven't tested them as a leading indicator. But we've seen three consecutive months of flat sales. That is, February, March and April were all around 16.5 million units [for car sales]. That's another indicator of slowdown in the economy.
GOING BACK TO YOUR POINT ABOUT THE YIELD CURVE, DOES THE FACT THAT IT'S BECOME A BIT STEEPER LATELY CONTRADICT YOUR OUTLOOK FOR SLOWER GROWTH?
Historically, a steeper yield curve has been an indication of future stronger economic activity. What it suggests is that the equilibrium structure of interest rates is perhaps moving a little bit higher, and the Fed to some degree is preventing that movement by holding short rates below a level where they would otherwise want to be. But, when the Fed started raising rates [nearly two years ago], the spread between the 10-year and the Fed funds rate was 370 basis points. Today, the spread is 40 basis points, and next Wednesday [the day of the next FOMC meeting] it's likely to be less than that when the Fed raises Fed funds to 5.0%.
If you look at statistical analysis of the spread and economic growth, 90 basis points tends to be the spread that corresponds with about 3.5% growth in the economy. Well, we're at 40 basis points and likely to go to something less than that next week from now.
THE FED'S TIGHTENING, IN OTHER WORDS
Yes, the [falling spread over time] is an indicator of Fed tightening.
By the way, all indicators of Fed tightening are out of fashion right now, except for the so-called real Fed funds right, which happens to be the worst indicator of Fed policy. Nevertheless, it's the one that's in favor right now.
WHAT'S THE REAL FED FUNDS RATE SAYING NOW?
Actually, it's also saying that policy's getting more restrictive.
WHAT DO YOU MAKE OF THE VARIOUS REPORTS OF LATE SUGGESTING THAT ECONOMIC GROWTH REMAINS STRONG?
Just because you have a strong report one month doesn't tell you what's coming in the next month. If real GDP growth were a great leading indicator, I guess it would be in the index of leading economic indicators. But it's not. Things can be very strong one quarter, and turn down the next.
THE JUMP IN GROWTH IN THIS YEAR'S FIRST-QUARTER GDP REPORT RELATIVE TO THE SLUGGISH FOURTH QUARTER CERTAINLY SUPPORTS YOUR POINT.
Well, it does. In the first quarter of 1990, too, there was very strong growth, and then we went into a recession. But when the numbers are strong, and your model is saying it's going to get weaker, it's scary.
IS IT HARD TO COME OUT WITH FORECASTS OF SLOWER GROWTH WHEN WALL STREET'S CONSUMED WITH THE REPORT DU JOUR SUGGESTING THE OPPOSITE?
It's very hard. Everyone's asking, What do you mean? Then there are the data revisions. Who knows? Maybe you're right now and they'll revise the data later on.
DESPITE THE RISKS, ARE YOU CONFIDENT IN YOUR SLOWER-GROWTH FORECAST?
It's like a technical model for the stock market: this is what it says.
AND YOUR MODEL'S CLEARLY WARNING OF SLOWER GROWTH?
Yes, it is clear. It's saying, there's a slowdown coming. Now, the model I use looks at year-over-year data because there's so much noise in quarter to quarter. And there already has been a slowdown on a year-over-year basis in real GDP growth. What I'm arguing is that we've got more to go with that--even slower growth.
WHAT ARE THE ODDS THAT A SLOWDOWN COULD TURN INTO A RECESSION? IS THAT POSSIBLE?
It's possible. Real M2 growth on a year-over-year basis is less than it was when we went into the last recession. That's a negative. Yes, the spread between the 10-year and Fed funds is still positive, but barely so.
WHAT DO YOU ADJUST M2 MONEY SUPPLY WITH? THE CPI?
No, I use the PCE deflator--that's what the Conference Board uses in its leading indicator. On a quarterly basis, in the first quarter basis, real M2 was up only 1.7% vs. a year ago. Just before we went into the recession of 2001, by comparison, real M2 growth in the first quarter of 2001 year over year was 4.9%.
WHAT DO YOU MAKE OF MR. BERNANKE'S CLAIMS, COURTESY OF CNBC'S MARIA BARTIROMO, THAT THE MARKET'S MISPERCEIVED HIS COMMENTS?
Here's what I think Bernanke's saying: We've done a lot, but the full force of what the Fed's done in the past has yet to be felt in the economy. The Fed has a forecast that economic activity is going to be moderating, and that forecast incorporates some of the lagged effects. So even though the current data are relatively strong, the Fed's forecast is that things are going to slow down.
Bernanke's also saying that the Fed's impressed that the core rate of inflation has not materially spiked higher, despite the price increases in energy and other commodity prices. The Fed's impressed too that unit-labor-cost growth has been very well behaved, despite a very low unemployment rate. And the central bank appreciates the fact that inflation is a lagging economic process. That is, inflation turns down after the economy turns down, not before.
So, Bernanke's saying that the Fed would like to pause [with interest rate hikes] for a couple of meetings to see if in fact some of the new data coming in conform to its forecast of slower growth. If that's the case, then maybe the Fed will stay on pause. If it's not the case, and the economy's growing stronger than forecast, then the Fed will resume tightening.
So, that's what I think Bernanke's saying. Normally, the Fed keeps tightening until there's a downturn in coincident indicators--not the leading indicators. It's obvious to everyone that the Fed has overdone it, so the Fed is attempting not to overdo it this time.
YOU THINK A PAUSE WOULD BE THE RIGHT THING TO DO?
Yeah, well, I think there are a lot of other things that are the right things to do, but it's a second best I guess. Let me put it this way: If you're worried about overshooting, about putting the economy into a recession, then I think a pause at this point is a prudent thing to do. You may have other worries, other things you're concerned about. But if you're trying to balance the risks between inflation and recession right now, I think the risks of recession are moving up quite dramatically.
WHAT ABOUT THE RISKS OF INFLATION?
I'd have to say that the risk on inflation right now, because of rising energy prices, is somewhat higher. I'd also have to say that if we didn't have [high] energy prices in the mix, the risks on inflation would be lower.
Inflation is a very complicated economic process. By contrast, forecasting the economy, although difficult, is easier than forecasting inflation. Inflation has a much longer gestation period, according to some analysis I've done. That is, about three years between changes in the money supply growth and changes in inflation.
Nonetheless, I think the Fed has already put in place some disinflationary policies. Now, that could be disturbed somewhat by higher energy prices. But if you look through that, disinflation policies are in place.
DOES THE FED'S CHOICE BOIL DOWN TO NIPPING INFLATION IN THE BUD OR PREVENTING RECESSION? MIGHT IT COME DOWN TO ONE OR THE OTHER?
Yes, it might. And that's the history of the Fed. The history is that it produces a recession, and then with a lag the inflation comes down. I just wrote a piece on this, called Federal Reserve and Inflation Targeting--First Do No Harm. Because of the different lag structures, what the Fed ought to do is just concentrate on creating credit at a constant, steady pace. That wouldn't eliminate cycles, but it would mute the amplitude of the cycles.
But there's no way they're going to do that. Part of the problem with the Fed is that we've come to expect that the central bank can, by printing money, can cure anything, even the common cold, maybe. The Fed tries to get involved in stabilizing real growth and that sows the seeds of inflation down the road. Then the Fed starts to fight inflation, and that produces recession. If they would put things on automatic pilot, a steady state, we'd probably have some recessions, but they wouldn't be major ones. You'd have some inflation, but it wouldn't get out of hand and it would [eventually] come down. We'd get away from the boom-bust type of cycles that we have now. Granted, this has been an extended boom, and there are some special reasons for it. But in the longer run, we'd probably be better off if the Fed tried to fine-tune less.
WOULD INFLATION TARGETING, WHICH FED CHAIRMAN BERNANKE HAS EMBRACED IN THE PAST, BRING THE FED CLOSER TO YOUR IDEAL FOR MONETARY POLICY?
Inflation targeting to me doesn't mean anything until you tell me how you're going to do it.
THE DEVIL'S IN THE DETAILS?
Yes. And what I've written today suggests a way to do it with money supply growing at a constant rate, which over time gives you a fairly steady rate of inflation. Not only would it damp the amplitude of inflation in terms of consumer prices, it would also dampen asset price inflation, which I think is as harmful as consumer price inflation.
That said, sometimes housing prices should go up, sometimes stock prices should go up. The Fed doesn't know what the right price of a house or a stock is. So, it gets back to do no harm. Just print a certain amount of money and let everything else do what it will. That's a free market approach.
SOUNDS LIKE YOU'RE NOT A FAN OF CALLS FOR THE FED TO PRE-EMPTIVELY PRICK IRRATIONALLY EXUBERANT BUBBLES
You wouldn't have bubbles to pre-empt [with my approach]. The bubbles get created by easy central bank credit. If you don't have the easy credit to start with, then you don't get the bubble.
May 3, 2006
DOES THE BOND SLUMP HAVE LEGS THIS TIME?
Pimco's Bill Gross pulls no punches in assessing America's investment alternatives in his freshly minted commentary for May. He's been wrong before, of course. It wasn't that long ago that he predicted that the Fed wouldn't keep raising interest rates. No matter, as the predictions keep coming:
"Higher inflation, higher personal and corporate taxes, and a lower dollar point U.S. and global investors away from U.S. assets and toward more competitive economies less burdened by health and pension liabilities – those personified by higher savings rates and investment as a percentage of GDP," writes Gross, manager of the world's biggest bond fund. If such a hint at his thinking doesn't suffice, he clarifies with, "Need I say more than to sell U.S. assets and buy Asian ones denominated in their local currencies; or if necessary to hire a global asset manager with sufficient flexibility and proper foresight to thrive in an increasing difficult investment environment?"
Bashing the U.S. investment outlook hasn't exactly been out of favor in recent years, although it's been a losing proposition when it comes down to dollars and cents. Despite the macroeconomic smoking guns that have been casting dark clouds over America's prospects, investors the world over have seen fit to ignore the strategic and favor the tactical. And it's paid off handsomely, particularly in the stock market.
A determined investor who bucked the then-bearish crowd and bought the S&P 500 Spider ETF in early 2003 is now looking like a genius, courtesy of the fund's 14.11% annualized return for the 36 months through yesterday, according to Morningstar data. That's well above the S&P 500's long-term performance, and probably a good deal more than reasonable minds expect going forward.
In any case, the rear view mirror doesn't reflect quite as favorably on bonds. The Vanguard Total Bond Market Index fund, which tracks the Lehman Aggregate Bond Index, has more or less treaded water over the past 36 months, posting a spare 2.43% annualized return through yesterday--about half the current yield on the 10-year Treasury.
In fact, the paltry gain for bonds has evaporated altogether in 2006. Vanguard Total Bond Market has shed more than one percent so far this year. But if the fixed-income world is flashing warning signals, you might have missed the caveat if your view came solely via the S&P 500 ETF. Year-to-date, the Spider has tacked on nearly 6%. At that pace, it's still on track for maintaining its impressive run by the standards of the past three years.
To be sure, owning both stocks and bonds satisfies the diversification itch, and this year's divergence in the two asset classes underscores the point. The question is whether the ongoing capacity of stocks to climb is a recognition of what awaits in the future or ignorance of the risks that are increasingly weigh on bonds?
Minimizing what ails the American economy has been popular sport, but the game can't last forever. Just ask forex traders, who've been selling the dollar in droves of late. The U.S. Dollar Index has dropped to its lowest level in about a year, a move confirmed by gold, which continues to soar to its highest level in decades by reaching nearly $669 an ounce as of last night.
Something is amiss in the outlook for America, and strategic-minded souls may be inclined to act on the fears. Maybe. Although the warnings will ring familiar--debt and deficits are the infamous buzzwords on every pessimist's lips--there's been a respite from any fallout. Perhaps it was the global savings glut that primed optimism's pump. Then again, the surge in corporate earnings and the undying desire among consumers to spend kept Wall Street buoyant. As such, who's to argue that the day of reckoning won't be delayed longer still, even beyond a date that sober-minded analysts of a certain predilection think is the absolute outside bet.
Regardless, the warnings are coming out of the woodwork (again), and there's reason to think that Mr. Market is slightly more amenable to gloomy notions in the wake of a bull market in stocks and the compression of risk-premium spreads. Indeed, a mere 250 basis points separates the yield in junk bonds (based on KDP High Yield Daily Index from the counterpart in the 10-year Treasury).
Perhaps the new parlor game will be one of looking for clues that might convince a majority that the glass is half empty rather than half full. A new paper from the Levy Economics Institute--Twin Deficits and Sustainability--has some thoughts on potential catalysts:
While household debt ratios, as well as debt-service ratios, have trended upward, an end to the current sluggish expansion is not likely to be initiated by a sudden wave of defaults and bankruptcies. Instead, it will come when household borrowers and banking sector lenders decide it is time to retrench—to slow the growth of borrowing by, and lending to, the personal sector. Conceivably, this slowdown could trigger a snowball of defaults.
The antidote to pessimism for the stock market is the usual balm: more earnings growth. And on that score, there's still reason to hope. As Dirk Van Dijk of Zacks asserts today, the median year-over-year growth rate for the roughly three-quarter of S&P 500 firms that have reported first-quarter earnings so far is 13.0%. In turn, the trend makes "it very likely that this will be yet another quarter of double-digit growth." He writes that the reports so far have been "amazingly positive, far more so than in the fourth-quarter."
But if it's still easy to be bullish on stocks, what's the argument for buying bonds? Maybe the cautious behavior that's swept over the fixed-income set is more than a fad du jour. If so, should an enlightened equity investor take note or just keep partying like it's the first quarter of 2006? Or, should we simply ask, how confident are you that the historically low correlation between stocks and bonds will hold up in the months and years ahead?
© 2006 by James Picerno. All rights reserved.
May 2, 2006
"It's worrisome that people would look at me as dovish and not necessarily an aggressive inflation-fighter," Ben Bernanke reportedly said on Saturday to CNBC's Maria Bartiromo, as she recounted via LATimes.com.
Bartiromo yesterday said she talked with the Fed chairman over the weekend at the annual White House correspondents' dinner, where she engaged the head of monetary policy on the matter of whether "the markets and the media [got] it right last week in terms of its reaction to your congressional testimony," the CNBC correspondent explained on Monday. Bernanke insisted that his aim was only to allow the Fed some "flexibility" in its management of the nation's money supply.
But if Bernanke intends to be the voice of persuasion in proving his hawkish mettle, he still has his work cut out for him. Indeed, there's a thin line between espousing the value of flexibility and being seen as dovish in Mr. Market's mind these days.
The next big chance for enhancing or diminishing Bernanke's newly acquired dovish patina comes next week, on May 10, when the Fed's FOMC convenes to consider interest rates again. To raise or not to raise will be the question, of course, although the futures markets is betting that another 25-basis-point hike is in the offing. But this time the stakes will be higher than with past rate hikes, which have been coming steadily in 25-basis-point increments since June 2004.
The Fed funds rate currently stands at 4.75%, and very likely will rise to 5.0%. But the current debate and uncertainty about the next move in June ill serves Bernanke's efforts to project an image of a steady, confident hand. The handover of the central bank from Greenspan, in other words, is foundering to judge by comparitive perceptions between the current and former Fed chiefs. To be sure, there's ample opportunity to keep the still-nascent stumbling from detiorating further, but the margin for error is getting thinner by the day.
The yield on the 10-year Treasury Note continues pushing higher, and the stock market arguably is turning skittish. In fact, yesterday's sharp and sudden selloff in the S&P 500 late yesterday has been attributed to news of Bernanke's Saturday evening confession. Mr. Market's forgiving mood is evaporating quickly.
In any case, whatever the FOMC decides on May 10 will cast reverberations further and louder than in past FOMC meetings. If another rate hike comes, it may raise expectations that more are imminent, driving home predictions that the era of cheap money really, truly is ending. If so, that raises the possibility of elevating all the attendant effects that typically come with a repricing of risk--a repricing process that's been notably soft in the recent past but may be on the verge of a quick return. Alternatively, if the FOMC surprises and holds rates steady, it's likely that bond market would finally rise up in anger with a sharp selloff in reaction to having been snookered. The bond ghouls of yore, in sum, may due for a return engagement after a lengthy sabbatical.
Meanwhile, Bernanke seems to have set himself up for some unwanted attention, courtesy of last week's coy remarks that the central bank might pause in nearly two-year odyssey of elevating the price of money. It's hard to imagine the Maestro getting himself hoisted by his own petard in this fashion. With the benefit of hindsight, it's clear that that Bernanke sent the wrong message at this point in the cycle. Yes, in theory, maintaining flexibility for crafting monetary policy has its merits. But running the Fed isn't about theory so much as putting ideas into action while minimizing any potential for market and economic fallout. Indeed, there are more than a few bits of conflicting reports about the future for economic growth and inflation, and the last thing Mr. Market needs is tortuous statements from the Fed chief about what comes next for rate hikes.
Yesterday's batch of economic reports only heightens the anxiety with stronger-than-expected growth updates, thereby undermining the Fed chief's embrace of the flexibility concept last week. Consider the smoking guns:
* Personal income rose by sharply by 0.8% in March, up from 0.3% in February
* Ditto for personal spending, which climbed by 0.6% in March, up from 0.2% previously
* In a sign of continued strength, March construction spending jumped a robust 0.9%, following February's 1.0% climb.
* The ISM Manufacturing Index rose to 57.3 for April, up from 55.2 in March, reflecting increasing strength in the sector.
"Clearly, the economy is holding onto all of the momentum it displayed in late 2005 and early 2006," writes David Resler, chief economist at Nomura Securities in New York, in a note sent to clients yesterday.
Similarly upbeat comments can be heard from Ed Yardeni, chief investment strategist at Oak Associates. "I am raising the odds of a better-than-expected economic growth scenario for this year, with the Fed continuing to raise interest rates," he writes in an email to clients this morning. "The latest batch of economic indicators for employment, income, consumer spending, housing, capital goods orders, and inventories is remarkably robust."
Mr. Bernanke, it seems, will have to redouble his efforts to fend off his dovish imagery he recently and inadvertently acquired. Flexibility is out for the moment, and projecting confidence is in. It's all about perception, of course. But ultimately, that's the biggest stick in any central bank's arsenal, and a stick that Bernanke can't afford to drop.
© 2006 by James Picerno. All rights reserved.
May 1, 2006
IS THERE A CONUNDRUM RESOLUTION ON THE HORIZON?
If you're wondering why Fed Chairman Ben Bernanke is being cagey when it comes to discussing when and if interest rate hikes will end, and for how long, take a look at the dollar.
The almighty greenback looks something less than invincible these days. The U.S. Dollar Index is off by roughly 5% from mid-March. The decline was unfolding for much of April, although the sellers found inspiration anew after Mr. Bernanke's suggestion last week--ever so carefully worded--that the central bank's rate hikes of the last two years may pause, if only temporarily, at some point in the near future.
As we wrote on Friday, this "new transparency" from the Fed chief isn't quite the epitome of the clarity that Bernanke has formerly embraced as the ideal for the central bank. To read his speeches of years past one would think the man atop the central bank would settle for nothing less than unambiguous broadcasting on the matter of monetary policy. Then again, perhaps his subtle retreat from that position is unsurprising, considering the delicate balancing act Bernanke faces in navigating the increasingly rocky shoals of monetary policy in the months and years ahead.
On the one hand, there's a strong argument that a continued squeezing of the money supply is necessary and essential for countering the inflationary forces that may be conspiring within the commodities bull market. The jump in oil prices in particular of recent vintage threatens to elevate inflation, if only marginally. As such, the Fed must counteract with monetary tightening. Yes, there's debate about whether higher oil prices are the inflationary threat they were in the past. But with the economy continuing to show robust upward momentum, it may be prudent to err on the side of caution and assume that the oil-as-threat is alive and kicking if not yet fully proven in the 21st century.
Of course, there's another view that the U.S. economy is set to slow, thereby taking away some of the inflationary winds that may or may not be blowing. True, this year's first-quarter GDP report released last week seems to belie the case that the economy's slowing. But economists say that the upward bounce in the nation's output in the first three months of this year won't be sustained at the 4.8% rate clocked in the first quarter. No, the economy's not about to contract any time soon, but even a slowing in the second quarter to, say, 3.5% from 4.8% would help take some of the wind out of inflation's sail.
Both of these scenarios have merit--thus Bernanke's conundrum on interest rates. Continuing to hike Fed funds risks giving momentum to a slowdown that would arguably gather steam as the year unfolds. It's never popular to have a central bank engineering economic slowdowns, but doing so at this juncture could hardly be more fraught with risk. There's no shortage of criticism that the expansion of recent years hasn't trickled down to the working class. Meanwhile, with anxiety about globalization, terrorism and an assortment of other frights, every downtick in GDP threatens to send some interest group or politician off the deep end with cries of foul about Fed policy.
At the same time, suspending rate hikes may give inflationary forces, albeit still nascent, breathing space to take root, strengthen, and haunt the economy down the road. Perhaps that's why the Fed chief has found reason to promote an on-again/off-again outlook with respect to the price of money.
Sensible perhaps, but espousing a gray area in monetary policy comes with risks in the spring of 2006. Indeed, forex traders smell blood. Even the slightest hint that the Fed is toying with the idea of suspending rate hikes has spurred dollar bashing. In the wake of Bernanke's comments last Thursday, the U.S. Dollar Index has suffered its biggest decline in more than a month. If the trend continues, it'll lead to more inflationary pressures by way of imports, which theoretically must rise in price to offset a cheaper dollar. That's no idle threat for the U.S., which posts a large and growing amount of red ink on its trade ledger.
If the bond market begins to smell inflation-importing risk in any material way, there will be hell to pay in the fixed-income market. Traders have already sold off the 10-year Treasury sufficiently to elevate the benchmark bond's yield above 5% for the first time in four years. A continued push higher in yield will surely trigger a reassessment of risk across the investment landscape. With most asset classes sitting on hefty gains of late, reassessment in any material way could be painful.
The much-anticipated bond correction may be set to arrive in earnest in 2006, triggering the same elsewhere. In fact, isn't that what the Fed has wanted all along since it began raising short rates in June 2004? Yes, although the plan was to ease long yields onto higher ground. But the fixed-income set resisted. Is the resistance now giving way to what some might term a higher level of financial sobriety? Meanwhile, if an inspired repricing of bonds is now upon us, will that bring a different result if it unfolds faster rather than slower?
© 2006 by James Picerno. All rights reserved.
FIDDLING WHILE OIL BURNS
Here's a news flash for Congress: there are no quick fixes. That statement of fact won't stop the pandering, but we're still of the belief that checking in with the truth as it exists, rather than as pols imagine it, is healthy.
Easier said than done. True to form, politicians are inclined to find a silver lining in an otherwise threatening cloud. When the cloud is energy, the knee-jerk reaction in Washington is to make grand proclamations that have no immediate relevance (such as President Bush's claim that America should decrease its dependence on Middle East oil), or else devise near-term "solutions" that are short on solution and long on drumming up votes.
The latest examples comes by way of the $100 rebate plan backed by the Republicans, which was spurned by at least one Democrat in the Senate as being ineffective, albeit by offering too little. Accordingly, the Democrat upped the ante and suggested a $500 rebate.
No one with a brain believes either idea will solve anything. Why, then, even propose the idea? We have our suspicions, and so do a lot of other people, which may be the reason that so many citizens are reportedly dismissing the rebate idea as more of the same from Washington's pols.
There's been one long energy crisis in America for more than 30 years, albeit a crisis that waxes and wanes in severity and at times appears dormant. Over those three decades, there's been a lot of talk about crafting a true energy policy but precious little action. Technology, of course, has delivered rewards, spurring efficiency and thereby saving fuel that would otherwise be lost. But technology is primarily a child of the private sector.
What's more, the easy gains from technology are behind us. There are countless new technologies that potentially will add up more advances in making existing supplies of oil go further, but their impact will be obvious only in the aggregate.
Meanwhile, far bigger rewards await in the political realm, if only the politicians could focus on the strategic and minimize the tactical. The past 30-plus years suggest that's easier said than done. Indeed, the past week suggests no less. Only in America, where a fundamental supply/demand energy squeeze is biting, does the legislature come up with the idea that handing out money will help. It won't. In fact, one could make the case that politicians should be advising the country that the days of cheap energy are gone. Instead, some pols are intent on keep the cheap-energy notion alive, even if only marginally and if comes at the price of using taxpayer dollars.
But the luxury of ignoring the challenge and instead trying to figure out a plan that maximizes vote-gathering success is an idea whose time has passed. It's up to the electorate to drive that point home to politicians running for office. Energy is increasingly the biggest issue on the table, and should be treated accordingly in elections. Energy purchases, in some cases, is a mechanism that indirectly funnels money to terrorists while consuming a large and perhaps rising share of GDP from here on out.
Here's an idea: asking each and every politician that asks for your vote: What's your energy plan? With the answer (or obfuscation) in hand, each and every voter can decide if it passes the smell test. After all, it's you're money. Now's a good a time as any to demand that it be spent wisely in promoting an energy plan that at least gives lip service to long-term success.
© 2006 by James Picerno. All rights reserved.