The Capital Spectator

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.

Posted by jp at 11:07 AM | Comments (1)

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.

Posted by jp at 9:47 AM | Comments (2)

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.

Posted by jp at 9:23 AM | Comments (0)

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.

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

May 5, 2006

BULLET TRAIN

The train kept a-rollin', all night long,
With a heave, and a ho,
Well I just couldn't let her go.
--The Yardbirds

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.

Posted by jp at 6:49 AM | Comments (3)

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?

Either way, yesterday's stronger-than-expected reports on factory orders and the service sector are the latest in a string of items that raise questions about what comes next.

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.

FOR EXAMPLE?
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.

Posted by jp at 10:21 AM | Comments (1)

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.