June 30, 2006
WATCH THAT DATA
Yesterday's 25-basis-point hike in the Fed funds rate--the 17th in a row--managed to surprise no one. But the accompanying FOMC statement was anything but routine this time around.
The central bank opted to keep the markets guessing a bit more with its latest prose. Let's call it the high art of espousing neutrality with a touch more gusto. David Resler, chief economist at Nomura Securities in New York, yesterday wrote in a note to clients that the FOMC statement "suggests more strongly than in those of the past that the future course of policy is now wholly data dependent." In other words, anything's possible, depending on the number du jour.
In any case, the threat of inflation is now firmly embedded in Fed thinking, as per the FOMC's advisory: "Readings on core inflation have been elevated in recent months." As a result, the notion that 25-basis-point hikes will now arrive like clockwork at each and every FOMC meeting has all but passed into history. In its wake is something different, which is to say that the Federal Reserve is more likely to surprise Mr. Market in the future than at any time since the central bank began elevating the price of money back in June 2004. Granted, if the data permits, the Fed may take a pass on another rate hike. But if the surprises go the other way, something tougher may come in terms of responses, and perhaps faster than you think.
One economist we talked with thinks Bernanke and company believe it's time to take off the kid gloves with the fixed-income set. In fact, the Fed is now prepared to adjust monetary policy to a degree and on a timetable that isn't necessarily obvious to the bond traders who've come to anticipate only modesty and predictability from the central bank. So says Robert Dieli, president and founder of the economic consultancy RDLB Inc., a Lombard, Ill. shop that also runs Mr. Model, an economics web site. More to the point, Diele tells CS that the Fed, if it feels obliged, may hike rates by more than 25-basis-points, and perhaps on a day other than the regularly scheduled FOMC huddle.
"If we get a bad consumer price index report, for instance, the Fed might do something the next day," Diele muses.
What convinces this 23-year veteran of dispatching economic forecasts that surprises may be the new new thing in monetary fashion this season? The data, in short, speaks to him, as he outlined in a report he penned last week titled Mr. Bernanke's Dilemma. In the essay, Diele advises that the Fed's hard-won respect on fighting inflation took the better part of a generation to acquire. It could be lost much quicker. Ideally, the state of monetary nirvana that characterizes the past decade or two comes when the Fed funds rate is sandwiched between the yield on long Treasuries above and core inflation, defined by the Personal Consumption Expenditures Index, excluding food and energy, below. No easy task, as the central bankers in the 1970s and early 1980s learned--the hard way.
Alas, this "comfort zone" that some thought had become the natural order of the universe is now in danger of evaporating, at least for the foreseeable future. The core PCE, in other words, appears intent on moving out and above this zone, as illustrated by a chart borrowed from Diele's report, reprinted below.
Source: Robert Dieli, www.mrmodelonline.com
The dilemma is that raising Fed funds, so as to coax core PCE lower in the months and years ahead, risks inverting the yield curve, which historically has been associated with subsequent recessions. Indeed, Fed funds are now at 5.25%--slightly above the 10-year Treasury's yield and equivalent to the 30-year's, as of last night's close.
The challenge of maximizing employment and minimizing inflation isn't new when it comes to thankless tasks that await the Fed. But neither is the job getting any easier. Much of Bernanke's success (or failure) will likely draw on his ability (inability) to convince the markets that he's the right man at the right time. But civility and manners aren't Wall Street's forte, and so the default reaction is one of casting more than a little doubt on the new man at the helm.
Yes, Wall Street's a tough crowd…usually. But it's always been so for newly minted Fed chiefs, Diele reminds. Even Paul Volcker, who had perhaps the most respect of any incoming Fed head in recent history, had to earn his stripes the hard way: by showing results. To be sure, history now judges him as one of the greats in central banking because he ultimately delivered the goods in the early 1980s. But in the beginning, the Street wasn't inclined to cut him any slack.
No less awaits Bernanke, who's already had more than his share of missteps in transitioning from academia to running the world's most powerful bank. But the window for forgiveness is closing, and at the moment actions speak louder than words (or one-on-one interviews with TV journalists at Washington parties).
Bernanke must convince the bond market that it needs to do more of the heavy lifting in nipping any inflationary momentum in the bud, Diele says. The baby-step approach of 25-basis-point hikes stretched out over time hasn't done the trick. Time now for something bolder, he counsels, assuming the incoming information implies as much. And don't even think about helicopters.
June 29, 2006
AN OBSERVATION WHILE WE WAIT…
We interrupt our regularly scheduled obsession with this afternoon's Fed announcement with an observation about the supply of dollars as it relates to the ongoing elevation in the price of money. To cut to the chase, we can't help but wonder if there's a weasel in the monetary henhouse. Hey, we've got to do something as we wait for the non-surprise that comes later today.
What are we talking about? Just this: the rate of increase in M2 money supply has shown a tendency to ascend this year compared to 2005. There's nothing especially intriguing about that, unless you consider that the central bank has been raising interest rates continually over that stretch. Ergo, what's wrong with this picture? Namely, a rising Fed funds without a corresponding decrease in money supply.
Indeed, the rolling 52-week change is M2 has moved higher this year relative to where it was for much of last year. The latest reading (which will be updated this afternoon, as it is every Thursday) shows M2 advancing by 4.7% over the level 52 weeks previous. That's nothing new by 2006 standards, which has shown M2's 52-week changes sticking mainly to increases in the 4.5%-5.0% range.
The plot thickens, however, if you compare this year's range to last year's. In particular, from May 2005 to the end of the year, the span of M2's rolling 52-week changes generally remained within the boundaries of 3%-to-4% ascents.
Perhaps the mismatch between this year and last is merely a technical hiccup, with no larger significance other than showing the machinations that accompany the business of manipulating, er, managing the money supply in the world's largest economy.
Then again, maybe not. We say "maybe not" in light of the large and growing pressures that rest on the American government to spend more than it takes in over time. Deficits, in other words, lurk within the financial system, driven by such budgetary perennials as Medicare and Social Security.
Yes, the jury's still out on how and when the associated deficits manifest themselves in altered fiscal and monetary policies than prudence otherwise dictates. Meanwhile, it helps to believe something's askew if you've got a touch of the conspiracy theorist in you. (For those needing some help on this front, a quick reading of The Da Vinci Code might help stir those juices, even if the fiction in this case overwhelms the factual. But we digress.)
In the meantime, the Fed will keep changing the price of money while adjusting its supply. Over time, the two are intimately connected. In the short term, the connection can be tenuous and even contradictory. Such is the nature of reading long-term trends from short-term observations. Of course, occasionally the short-term contradictions offer early clues about changes in long-term policy. Deciding what prevails at the moment amounts to the art of observation. This, then, dear readers, is the golden age of observation in Fed matters.
With that, we now return you to our regularly scheduled Fed-watching program….
June 28, 2006
COOL DATA & HOT CHOICES
Tuesday's update on existing home sales confirmed what Monday's new home sales only hinted at: the real estate market's cooling.
May's tally of existing home sales (by far the larger data sample compared with new homes) dropped 1.2%, the National Association of Realtors reported yesterday. That's the second monthly decline in a row, while May's sales are off 6.6% from the year-earlier figure.
The Northeast U.S., the leading property market in the country, suffered the biggest hit in May, with sales of existing homes falling by 4.2%. Meanwhile, the West through last month endured the worst year-over-year comparisons, posting a -13.5% stumble in sales as of May.
This, dear readers, is what a cooling housing market looks like. And given the outlook for interest rates, which is still up, expect more of the same from the world of housing.
Additional clues of a slowdown in the formerly red-hot property market can be found in the stocks of home builders. Indeed, among the 129 equity industries tracked by Morningstar, home building is dead last in performance terms so far this year through yesterday, posting a -28.5% collapse. By comparison, the S&P 500 is up fractionally so far this year with a 17-basis point return through last night.
Retreating prices among home builders comes as no surprise for those who watch these companies. Indeed, Lennar Corp., a leading publicly traded home builder, became the latest in the industry to shave its outlook for 2006 earnings. Although the company reported a better-than-expected quarterly profit, investors weren't satisfied, and proceeded to sell the shares by three percent on the day by the close of Tuesday's trading. Forward-looking perspectives are all that matter these days in real estate, and the morrow continues to give reason for caution.
A Morgan Stanley research report issued on Monday reflected the gloom about real estate that's found traction on Wall Street of late. "Given the deterioration in fundamentals across all of Lennar's markets during the second quarter, combined with management's focus on driving volumes to the detriment of margins, we believe guidance could face further downward revisions," Morgan Stanley wrote, via MSN Money. "We believe Lennar faces near-term operational challenges that are likely to result in further negative earnings revisions and the underperformance of the stock."
If the cycle has turned, the Fed should be happy. Nudging real estate's momentum to bearish, if only slightly, from bullish was the game plan all along, right? Consumer spending, fueled by soaring home equity values, needed to be taken down a notch in order to take the edge off inflationary momentum that has spooked the central bank in recent months. As such, one might wonder if now there's enough restraint injected into the system to put the interest rate hikes on hold--after tomorrow, that is.
But before we get ahead of ourselves, let's point out that tomorrow seems fated for another 25-basis-point hike, elevating Fed funds to 5.25% once the dust clears at today-and-tomorrow's FOMC meeting. Fed fund futures have been steadfast in predicting no less over the last two week.
But the financial crowd is getting restless as it looks out into the summer. On the leading edge of anxious money managers is Ed Yardeni, chief investment strategist at Oak Associates and co-manager of the Oak Fund. "Fed officials are unnecessarily, and perhaps dangerously, destabilizing global capital markets by exaggerating the inflation problem in the U.S.," he and Steven Einhorn of the hedge fund shop Omega Advisors wrote in a research note this morning. "They are also confusing investors about how they are monitoring and assessing the extent of the problem and how they are likely to respond to it."
On the second complaint, we couldn't agree more. As for the first, we're not so sure--at least not yet. It's a given that the Fed will err in its monetary policy. That's the nature of systems devised and managed by humans fated to make forward-looking decisions with lagging data points. Witness the deflation scare of a few years back. The Fed decided to err on the side of fighting deflation. As it turned out, that fear was misplaced. In any case, the result in the here and now is one of mopping up the resulting excess liquidity, which has a tendency to bite back long after its initial arrival.
The Fed now faces the thankless task of deciding how and when to err, a game otherwise known as monetary policy. For our money (no pun intended), erring on the side of caution still makes sense, if only slightly. As Fed Chairman Bernanke observed a few years back, injecting liquidity into the economy takes about as much time and effort as falling out of bed. The reverse action, by contrast, is usually a slow and often painful process, and one that's further complicated if the central bank tries to live up to its other primary mandate of maximizing employment.
If the Fed is proven to be wrong in erring on the side of nipping any inflationary momentum in the bud, it can always reverse course in a heartbeat. On the other hand, if it's too dovish, and allows inflation to gain a stronger foothold, correcting for that error could take a generation, as the late G. William Miller (Paul Volcker's predecessor as Fed chief) learned the hard way.
June 27, 2006
HOPE & FEAR, AGAIN & FOREVER
Yesterday's latest release of new home sales renewed talk that the much-discussed slowdown in housing has been greatly exaggerated. Don't believe it. A cooling of the property market is unfolding. What's debatable is the type and degree of aftershocks that will accompany the slowdown. On that, at least, there's reason to pare one's fears, if only slightly.
Yes, the May data for new sales of single-family homes for last month posted an unexpected pop, the U.S. Census Bureau reported yesterday. What's more, the gain in May not only exceeded the consensus forecast; it was also the third straight month of higher sales, as the chart below illustrates.
But lest one thinks it's time to rethink the notion that the real estate market is defying gravity, consider the broader perspective.
For starters, the number of homes sold dropped by 5.8% to 1.23 million, as of last month relative to a year earlier. Over the same period, the number of houses for sale jumped by nearly 24% to 556,000. More houses for sale and fewer sales. You don't have to be an expert in property management to take the hint of what's coming.
What's behind the rise in the supply of houses for sale while the number of homes sold has dropped? Perhaps it's the fact that mortgage rates are rising, making it more financially burdensome to buy homes. The standard 30-year fixed-rate mortgage was 6.83% last week--the highest in more than four years, according to a survey by Bankrate.com. The Fed seems inclined to keep that rate moving higher, insuring that the relative allure of real estate will wane further.
For the growing number of households with variable-rate mortgages, higher rates pose a more direct threat. As David Kotok of Cumberland Advisors notes in an email note to clients, "$1 trillion in mortgages reset higher this year. $1.7 trillion next year. When mortgage interest rates rise and impact over 10 million households in two years, you must get a slowing."
The mindset that expects a slowdown in real estate and beyond finds a nurturing home at
Lombard Street Research, a macroeconomic forecasting outfit that monitors the data from London. Last week, Lombard analyst Gabriel Stein warned that raising Fed funds beyond the 5.25%-to-5.50% range "would be a mistake." Fearing that inflationary momentum is gaining traction, the Fed might elevate rates above 5.50%, Stein muses. But inflation is a backward-looking indicator, he reminds. In addition, the rate of increase in the U.S. money supply, measured by M2, has slowed sharply recently, he adds. The latter is a more reliable indicator of future inflation, as per the monetarism of Milton Friedman. The bottom line: "the U.S. economy is headed for a slowdown," Stein wrote, and the Fed looks set to insure that outcome, albeit by way of erroneous rear-view mirror analyses.
Meanwhile, to return to the property market, if the economic slowdown turns on the pace and degree of real estate's cooling, what are we to infer from the mini boom underway in home sales? The optimistic view is that any property correction will be of the soft-landing variety, helped by growth elsewhere in the economy, as one analyst opines.
Don Luskin, chief investment officer of TrendMacrolytics, is a leader among the optimists on this score, pointing out in a note to clients yesterday that the slowdown fears on Wall Street are overdone. "As the conventional wisdom once again embraces the idea that the economy is headed for a sharp slowdown," Luskin wrote, "one of the most reliable indicators of future economic performance is saying 'full speed ahead.' Consensus bottoms-up forward earnings for the S&P 500 are surging forward, seemingly oblivious to the slowdown that is supposedly just around the corner. They've been surging steadily over the last three years, while a bull market in stocks and a roaring economy have climbed a classic wall of worry."
Right or wrong, informed or ignorant, the Fed will raise rates again at this week's FOMC meeting. Deciding if that proves enlightened remains a battle of import among the bulls and the bears. The strategic war is still up for grabs, but the risks that naturally accompany being wrong are still a clear and present danger.
June 26, 2006
THE GREAT IMBALANCE & THE FED
The Federal Reserve weighs in again this week on the price of money. Functionally, nothing's changed. It's just one more summit on engineering an interest rate that a select group of Fed officials see as optimal. But measured by the context of the current global economy, the stakes in this week's decision on the Fed funds rate are higher than before. In fact, that progression of an ascending ante promises (threatens?) to hold fast for the foreseeable future FOMC confabs.
For the one that arrives on this Wednesday and Thursday, the pressing question turns on where to err? On one side is the preference for nipping inflation's momentum of late by elevating interest rates yet again, and thereby risking an economic slowdown of greater magnitude than would otherwise unfold. The alternative (which still appears out of favor but nonetheless within the realm of possibility) favors growth by keeping Fed funds at the current 5.0%. In theory, a third choice beckons: cutting rates, but almost no one believes this one's a viable choice at the moment.
Deciding where the path of greatest prudence (or minimal recklessness) lies rests largely on how one sees or ignores the risks that lurk in the global economy. The Bank for International Settlements (the so-called central bank for central banks) last week handicapped the future on this score by opining that "the best bet for next year is that strong, non-inflationary growth will continue," according to the new annual report for BIS. If so, the Fed's job will be infinitely easier by widening the margin for error considerably in matters of monetary policy.
But even an optimistic take on what comes next shouldn't ignore what might go wrong, and the new BIS publication lays out the range of possibilities with clarity. Summarizing the yin and yang of outcomes that may arrive in global economics boils down to the BIS advisory "there are considerable uncertainties and associated risks, not least concerning inflationary pressures on the one hand, and a possible unwinding of accumulated economic and financial imbalances on the other."
To be precise, and somewhat narrowly focused, one could argue that the savings deficit that prevails in the United States relative to the accumulated cash on China's balance sheet constitutes the great global financial imbalance of the moment. Clarity on what it means is in short supply, but there is a surfeit of questions that pester and pursue the otherwise unapologetic optimist. To cite just a few of the inquiries for which there are, as yet, no definitive answers:
* Is the great imbalance destined to correct?
* If so, will the correction come quickly or unfold over years or even decades?
* What might the implications of a correction be?
* How does one's decision on the aforementioned questions inform an enlightened asset allocation policy?
Invariably, one's risk tolerance, investment horizon and financial goals should provide the primary guidelines for crafting a portfolio strategy. On that score, ours is one of erring on the side of caution, a decision that's supported by our reading of valuation levels in the major asset classes, which is to say, nothing looks particularly compelling on an historical basis. Cash and short-dated bonds, as a result, have the edge in our strategic thinking these days. That may prove to be painfully wrong, but for the moment we're willing to assume the risk. Correcting the global imbalance, if it comes in its most-potent form, would mean, among other things, a sharp drop in the dollar and a commensurate rise American interest rates. The odds of that happening may be low. But since we're inclined to preserve wealth at the expense of growing at the current juncture, ours is defensive posture. So be it. We'll take whatever lumps will follow, but at least we'll be sleeping soundly.
More importantly, the world awaits the Federal Reserve's inclinations on weighing risks. With the Bernanke era not yet six months old, the capital markets are still assessing how the Fed chairman thinks and acts. Of particular interest is the question of how the former Princeton professor evaluates the great imbalance relative to the prospects for an economic slowdown and higher inflation. In the recent past he's embraced a wide latitude of explanations that might affect his thinking on policy. But the miracle of the "savings glut" argument of a few years back has been replaced by tougher talk on inflation, and so one could argue that the evolution of Ben has removed some of the mystery surrounding his outlook.
But FOMC meetings speak louder than words. The future's uncertain, although it arrives in convenient daily packages, sprinkled with clues and the occasional flavoring of obfuscation. The next installment arrives on Thursday. Aloha!
June 23, 2006
JOE TODAY, GONE TOMORROW?
The economy of the United States is the wonder of the world. Growth is a perennial favorite, banishing all who expect anything less to the margins of pessimism's dungeons. Ours, dear readers, is an era of economic resilience. The reason, as always, is that our hero, Joe Sixpack, is willing to spend till he's red in the face (and on his balance sheet). Representing some 70% of the nation's GDP, Joe and his counterparts are collectively the engine that defines and drives American economic muscle.
Joe's inclination to keep spending these days, in turn, is powered by an inclination to keep borrowing, which corporate America has seen fit to make progressively easier over time without regards to creed, color or credit quality. The Federal Reserve this month put a new number on the extent of Joe's readiness to engage in the most popular of American financial transactions: spending someone else's money. In the first quarter of this year, the growth of household nonfinancial debt jumped by 11.6%, on a seasonally adjusted annualized basis, according to the Fed's Flow of Funds report. That's near the fastest pace of recent years, and well above the 6%-to-10% range of increase that prevailed during the latter half of the 1990s, a stretch that was no stranger to robust economic growth.
The Federal Reserve conveniently breaks down Joe's fondness for red ink into two main categories: home mortgage and consumer credit. As the chart below reveals, 'tis the home mortgage category that's doing the heavy lifting in elevating household debt to levels that worries some but otherwise encourages others.
In any case, home mortgage debt advanced by 13.6% in the first quarter, far above the relatively paltry rise of 2.2% for consumer credit. But what are we to make of the sizzling gain in home mortgage debt?
Perhaps, the optimists say, the mortgage debt isn't quite as red as it appears. Buying homes, after all, incurs debt, but debt that funds an appreciating asset is something to be praised, as opposed to taking out loans for cars, televisions, and furniture, all of which drop in value as routinely as water flows downhill. Ergo, there is good debt and bad debt, and woe to the analyst who doesn't make the appropriate distinction.
So be it. The Capital Spectator has come to praise enlightened borrowing, not bury it. But when is too much of a good thing too much?
In search of an answer, or at least the crumbs of a clue, let's observe that home mortgage debt, as the Fed defines and tracks it, includes loans made by way of home equity lines of credit and home equity loans. And as the Fed also reports in the latest Flow of Funds, home equity loans have been on the march, rising to by 18% for the year through this year's first quarter. Overall, the $1 trillion-plus of home equity loans in the first quarter has roughly doubled since 2001.
And what is Joe doing with all that borrowed money? In theory, he might be plowing it back into appreciating assets, although the sales figures at the likes at various retailers suggest otherwise. Indeed, buying ever larger homes compels homeowners to furnish them. It's a vicious, albeit retailer-friendly circle.
In any case, it's a safe bet that the weakness for dipping into one's home equity has blossomed thanks to the convergence of two trends--trends that are themselves not unrelated, namely, cheap money and rapidly appreciating home values. But as recent events have detailed, those trends aren't quite what they used to be, and may stumble more in the months and years ahead. The question then necessarily becomes: what does that imply for Joe's spending and borrowing habits, and economic growth?
To be sure, the answer will have no immediate affect on today, tomorrow or next week. Secular trends are slow-moving animals, and too are transitions in such. Nonetheless, embracing the strategic has its merits, even if it's not immediately obvious in the here and now.
June 22, 2006
DOES ECONOMIC PROGRESS IMPLY LOWER RETURNS FOR EMERGING MARKETS?
The allure of emerging market stocks is rooted in the notion that higher risk begets higher reward. But what happens if the higher risk loses some altitude? Does that imply that prospective returns will follow?
Such questions are topical these days in the wake of news that the financial profile of emerging market economies has improved considerably in recent years, and is poised for more of the same going forward. But will fiscal progress pare the extraordinary returns that emerging markets have been known to deliver relative to developed markets?
One indicator of the improving financial health of emerging countries can be found in the narrowing interest-rate spread of debt issued by these markets relative to high-grade bonds from developed countries. At the end of this year's first quarter, the risk premium in yield for emerging market bonds was roughly 100 basis points over AAA-rated debt, according to the IMF's 2006 World Economic Outlook. That's a fraction of the 1,000-basis-point spread that prevailed in 1999.
The decline in risk spread has been driven by more than rank speculation. The underlying economic trends in emerging markets has been generally positive in the 21st century, in some cases extraordinarily so. Private capital net inflows, for example, have risen sharply for emerging markets in recent years, more than doubling in 2005 to $254 billion from just three years earlier, according to IMF data.
In addition, more emerging market countries are paying off debts and sitting on large cushions of cash, often because of booming exports. China is the obvious example, having amassed the world's second biggest stash of Treasuries after Japan. Another example: Brazil announced last December that it would pay off its entire $15.5 billion debt to the IMF--well ahead of schedule.
No wonder then that emerging markets have been stellar investments in recent years. Consider that in local currency terms, the MSCI Emerging Markets Index has climbed by an annualized total return of 15.6% a year for the five years through this past May. By contrast, the standard benchmark for developed market equities, the MSCI EAFE, has advanced a paltry 0.8% a year over that stretch, measured by local currency terms.
But if emerging markets are doing so well, and looking a tad more like developed economies in terms of self-financing and higher financial ratings, shouldn't the returns generated by these markets also look more like their developed-market brethren? In other words, is the case for breaking out emerging markets as a separate asset class waning?
Not necessarily, advises Curtis Mewbourne, executive vice president at Pimco, the giant bond shop. Although he considers emerging markets primarily from a debt investment perspective, he explains in a new essay that the main allure of emerging markets is their relatively high economic growth rates. The fact that they're paying off debt faster than some expected doesn't change the rosy outlook for GDP growth in many of these countries.
"According to the IMF, emerging economies account for 48% of global GDP...and these economies are growing at an average rate of 7% versus 3% for the developed economies," Mewbourne writes. "Thus their share of the global pie is large and growing."
One supporting milestone can be found with the so-called BRIC countries--Brazil, Russia, India and China, which are the four largest so-called emerging market economies. Last year, for the first time, the combined GDP of the BRIC nations exceeded that of Japan, the world's second-biggest economy, Mewbourne notes. The BRICs are reportedly growing at an average nominal rate of 10%, or more than three times as fast as Japan. "If those rates of growth continue, then China’s nominal GDP will be larger than Japan’s within a decade," he writes.
Overall, Mewbourne opines that the emerging markets as an asset class "is undergoing an important structural change, namely an expansion of corporate financing and a migration from external to domestic financing."
If economic maturing is a problem, one might expect to find it unfolding in South Korea, a former emerging market country that some economists now consider as a fully developed nation. If so, the developed status suits South Korea. For the three years through last month, the MSCI Korea Index has climbed by an annualized 36.9%--easily beating both the MSCI EAFE and MSCI EM indices over that span.
But even an optimist like Mewbourne recognizes that volatility will remain standard fare with emerging markets, fiscal prudence or not. Yes, the long run may look bright, but in the short run emerging markets are still a roller coaster.
Indeed, the MSCI EM in local currency has crumbled by more than 9% in the four week through last night. The local currency version of MSCI EAFE, on the other hand, is off by just 3.8%.
Some things never seem to change with emerging markets. Perhaps, then, long-term investors have nothing to fear. Higher risk appears to be alive and well in emerging market stocks. Will it continue to translate into higher returns? History suggests as much, at least for those who can hang on for the wild ride that surely awaits.
June 21, 2006
READING REAL ESTATE'S LATEST TEA LEAVES
Among the countless economic variables that the Federal Reserve routinely parses for inspiration on what to do next in monetary policy, real estate's numbers no doubt carry significant weight these days. The housing boom in recent years has delivered a more than a little zest to the economy, courtesy of the ample liquidity that the central bank has supplied in years past. As such, if there's any chance that the Fed would cease and desist in its current round of interest-rate hikes, real estate trends are likely to deliver an early warning.
What, then, should we make of yesterday's release of May's housing starts, which posted a 5.0% rise over April's numbers--the first month-over-month increase since January? Is the real estate boom resuming? Is the former slowdown that we've been hearing so much about over?
Not necessarily. As Asha Bangalore of Northern Trust observes in a research note to clients yesterday, "Two-thirds of the increase in [housing starts in] May was from new construction of multi-family units, which tend to show a larger degree of volatility compared with the starts of single-family units. The rebound in May is tentative, at best. News from the housing market is marked with stories of declining orders and lay offs."
In fact, confidence among home builders has continued to drop precipitously this year, as tracked by the National Association of Home Builders/Wells Fargo Housing Market Index (HMI). The latest installment for June, released on Monday, maintained the trend: HMI dropped to its lowest level since 1995, NAHB reported. The cause? Rising mortgage rates, higher price hurdles for buyers, and the retreat of investors/speculators from the marketplace, according to NAHB's press release. Adding to the gloom was the news that the fall in builder confidence was "broad-based and registered in every region this month."
Meanwhile, UCLA Anderson Forecast, a research outfit in Los Angeles, says that a real estate slowdown is underway in California (the biggest real estate market in the U.S.) and the nation overall. But optimism nonetheless springs eternal. In a press release issued today, discussing the group's just-published second-quarter property report, UCLA Anderson Forecast Director Edward Leamer is quoted as saying: "We do not predict a recession, nor do we predict a substantial decline in average nominal home prices." Ratcliff goes on to explain the reasoning for this sunny outlook. "There is not enough vulnerability in the usual sources of employment loss to create a recession, and the historical record suggests that average home prices do not usually fall without this kind of job loss."
Indeed, the 4.6% unemployment rate for May is the lowest since July 2001. If there's an employment speed bump coming, it's not obvious in the jobless rate. But countering that trend is the rise in the nation's nonfarm employment last month--the lowest since last October, representing a sharp slowdown from the strength that previously graced the employment reports in 2006. The nation's capacity to produce new jobs appears to be tired. Another month or two of confirming data and the markets may conclude that a recession is in fact imminent.
But that's a debate for future economic releases. In the here and now, another reality dominates. Futures traders, at least, aren't being swayed from their prediction that the Fed will raise rates by another 25 basis points next week, when the FOMC meets next on June 28/29. The July Fed funds contract is priced in anticipation for a 5.25% Fed funds as of next Thursday.
As real estate slowdowns go, the current one (if in fact that's what we have) is so far mild, at least in the minds of traders. The question, then, is what, if anything, might change the mindset in the land of futures? Potential candidates include tomorrow's update on jobless claims, and Friday's durable goods report. With another number always just around the corner, greed or fear are in theory never far behind.
June 20, 2006
REITs KEEP RUNNING
If there's such a thing as consistency in the capital markets in the 21st century, real estate investment trusts are the standard. Although the asset class has had its share of frights from time to time, REITs nonetheless managed to right themselves and post gains once the dust cleared.
The tendency to post returns in the black is again on display in 2006. So far this year, through last night's close, REITs are up 9.30%, as per Vanguard REIT Index Fund. And as our chart below shows, REITs are also the leading asset class ranked by returns for the past month through yesterday. To find a calendar year in which REITs shed ground one has to go back to 1999, when the category retreated by 4.0%.
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.
Such consistency is otherwise unavailable in the competing asset classes, at least when considered through the prism of recent performance. Foreign developed government bonds (based on the dollar-hedged PIMCO Foreign Bond Fund) appear to be a close second, as our chart shows. Indeed, this asset class also hasn't had a down calendar year so far in this century. But where the category stumbles is absolute total return. PIMCO Foreign Bond posts a 5.24% annualized total return for the past three years through yesterday v. a sizzling 18.6% for Vanguard REIT Index Fund.
REITs, in other words, have no equivalent among the major asset classes when it comes to ongoing gains, high absolute performance over time, and a bull market that's been second to none in consistency and stability.
So, what's not to like? A realist might answer that question by pointing out that the laws of financial gravity haven't been repealed, even if the recent empirical record for REITs suggests otherwise. At some point, all asset classes--particularly for those of the equity variety--go through relatively lengthy periods of pain. Yet REITs have largely sidestepped that awkward law that otherwise afflicts competing assets. Alas, assuming that the past dictates the future is an assumption that has cost investors dearly in the annals of finance.
To be sure, REITs appear to be beating the odds. And since investors are influenced more by recent rather than distant history, the tendency to project performance of late going forward is all too enticing.
By contrast, some (including your correspondent) has warned in the past that the fun has gone on for so long, and with such gusto, that cutting back on the asset class has been the only enlightened choice. Yet that enlightenment has come at a steep opportunity cost in recent years. Each and every sharp correction in REITs has quickly led only to a rally that brought prices to yet new record levels.
Paring asset classes that have run sharply higher over time while overweighting those that have suffered is a strategy we believe in. Unfortunately, that strategy hasn't worked with REITs, although it seems to be reaping gains of late with emerging markets stocks. No matter, as we're not willing to discard a strategy that has proven itself worthy over time. Diversification, in short, still matters, even if it suffers embarrassment in the short term.
There is no diversification without rebalancing. REITs, we're sure, will one day correct. But not today, perhaps not this year, and perhaps not any time soon. But eventually, all bull markets must end. All of financial history offers no exceptions.
The question: how much will our diversification-inspired prudence cost us in an asset class that seems intent on defying the odds?
June 19, 2006
THIS IS NO TIME FOR A NERO COMPLEX
There's a school of thought in the investing world that believes in taking central bankers' warnings at face value. Easier said than done. Fed commentary hasn't exactly been surgically precise in the spring of 2006. The central bank has been inclined to suspend interest-rate hikes only to rethink such a halt, depending on who's doing the talking.
But last week's remarks from St. Louis Fed President William Poole seem to have put the matter to rest on what should come next regarding next week's FOMC meeting and the related matter of the price of money. "If the inflation rate continues to be persistent like this," he said last week, "the Federal Reserve will simply have to pursue persistent policies that will keep that inflation from increasing further."
Poole was referring to last week's release of May consumer prices, which, by any measure, are continuing to surprise on the high side. Consumer prices rose by an annual rate of 5.7% for the three months through May, the Labor Department reported last week. For those keeping score, that's 70 basis points above the current Fed funds rate, a premium that amounts to an "ouch" for inflation hawks. Meanwhile, the so-called core rate of inflation (consumer prices less food and energy) advanced by 3.8% at an annual rate for March through May--the highest since 1995.
Taking it all in, there's no longer reason to wonder if inflation is edging up--confirmation has arrived. The only question is how high is up? That depends on what the Fed does in coming months, starting with next week's FOMC confab.
For perspective, keep in mind that some (if not most) of the uptick in inflation of late derives from the exceptionally loose monetary policy of previous years. Aggressively printing dollars for several years in the early years of this century is now coming back to haunt the system. Reversing the former liquidity boom will take time, probably years. Assuming, of course, the Fed has the stomach for the monetary fight that looms.
To be sure, no central bank exists in a vacuum. The willingness of the Fed to elevate the price of money for the world's reserve currency may find some degree of support in central banks around the world. If the major overseers of currencies on the planet find reason to tighten, the Fed's job will be that much easier, at least in a political sense.
Consider then last week's economic news for Japan: first-quarter economic growth for world's second-biggest economy was revised sharply higher to an annualized inflation-adjusted 3.1% from the previous 1.9% estimate, representing the fifth-consecutive quarter of growth in the Land of the Rising Sun. How high is 3.1%? Nearly twice as high as the 1.82% yield on a Japanese government 10-year bond. Rarely has the case for a rate hike in Japan been so clear and compelling.
The mind-set for similar action is taking hold of policy makers can be found in the U.S. as well, albeit in milder form. GDP's rate of ascent for America in the first quarter was a sizzling 5.3% in the first three months of this year, or slightly above the 5.13% that currently defines the yield on a 10-year Treasury. Yes, a slowdown in economic growth is coming. But broad confirmation of that forecast won't come until July 28. But the Fed doesn't have the luxury of waiting that long.
Sitting on one's monetary hands for more than a month, given the latest dispatch of inflation numbers, is the financial equivalent of fiddling while Rome burns. Fed Chairman Bernanke can't afford a Nero complex at this juncture, and neither can the U.S. economy. In fact, sending a hawkish signal by way of a 50-basis-point hike next week might be just the thing to establish Bernanke's credentials while the aura of economic growth still hangs in the air. Retreating later on would be easy, if GDP falters. By contrast, going soft now, and trying to catch the inflation train down the road only promises trouble by way of a diminished odds of success. Ergo, the June 28/29 FOMC may prove to be one of the more crucial meetings (for good or ill) in Bernanke's tenure.
June 10, 2006
THE CAPITAL SPECTATOR'S ON VACATION
Yes, it's true. We're laying down our analysis, putting our pen to repose, and otherwise cooling our publishing heels. But just for a week. That, at least, is the plan as we decamp to warmer climes for a short break. But we'll be returning on Monday, June 19, and dispensing more of the usual. Presumably, there'll be a story or two waiting for us.
June 9, 2006
THE ECB FACTOR KICKS IN
The hike was 25 basis points, but raising interest rates by 50 bips was considered, European Central Bank president Jean-Claude Trichet said today after the monetary tightening. "The overwhelming majority of the governing council thought that a 25-basis point increase was appropriate," Europe's top banker reported at a news conference today, according to RTE Business. "But we did weigh the assets and liabilities of a 50-basis point rise."
In the United States, the Federal Reserve was recently considering zero as the operative change for the next change in interest rates but has since decided that a 25-basis-point elevation is the more prudent choice after all, or so Fed futures are predicting.
The pressure from abroad to elevate the price of money is rising on the American central bank, if only to keep the yield premium intact relative to the primary paper alternative to the dollar. That pressures promises to be an ongoing one for the foreseeable future, Trichet advised. "If our (recovery) scenario is confirmed, then further withdrawal of monetary accommodation is warranted," the ECB chief said. For the United States, which relies in no small part on foreign purchases of Treasuries to fund the government's deficit, paying attention to the relative attractiveness of government bonds is a big deal.
With the latest hike, the ECB benchmark refi rate is 2.75%. That's still a long way from the current 5.0% Fed funds, although the gap is, for the moment, narrowing. In fact, the ECB's tightening, and its stated intention to perhaps offer more of the same down the road, has marginally reversed the dollar's recently rally this morning. A warning sign, if you will, albeit a small and so far marginal one. But with the threat of marginally enhanced competitive yields abroad, forex traders have decided sell the greenback for the moment if only to reconsider the in days and weeks ahead.
The Fed's response, if any, to rising rates in Europe will come at the end of the month, when the FOMC convenes again on June 28/29.
Adding to the general aura that another rate hike is need for the U.S. is the latest forecast by the White House, which, presumably, is inclined to soft pedal this outlook for political reasons. All the more reason then to consider that the Bush administration says inflation will average 3.0% this year, up from its previous 2.4% prediction.
If the stars are aligning for another rate hike, the bond market finds the trend encouraging. The yield on the 10-year Treasury at one point in early trading today dipped ever so slightly below the 5.0% mark, suggesting some confidence that the Fed will in fact err on the side of caution when it comes to the recent spate of inflationary pressures.
If there's a renewed commitment to nip inflation in the bud, the bond and stock markets could yet face more turbulence as investors digest the proposition. But if the Fed can keep its statements focused on the long haul, and avoid speculating on the next data point release, perhaps there's a chance for rallies in stocks and bonds as the summer proceeds. The capital markets like nothing better from their central banks than promises of stability in prices and a committed, long-term focus on pursuing just that. But lest we get too optimistic, let's also remember that the new era of central banking (i.e., one where disinflationary winds are no longer blowing free and easy) has only just begun.
June 8, 2006
YESTERDAY'S GONE & TOMORROW NEVER KNOWS
If the Federal Reserve is looking for an excuse not to raise interest rates at the June 28/29 FOMC meeting, it didn't find one in yesterday's release of consumer borrowing for April. Yes, April's numbers are old, bordering on ancient, coming at a time of increasing anxiety as Wall Street and the Fed are desperately looking for clues about what comes next in the economy. But something is better than nothing (maybe), and two-month old data will have to do.
As such, the unexpectedly sharp rise in consumer borrowing in April extends one more reason, however flimsy, to think that Bernanke and company will vote to elevate Fed funds by another 25 basis points come the end of this month. Indeed, consumer credit (defined here as excluding mortgage loans) jumped by an annual rate of 5.9% in April, the Federal Reserve reported. That's the fastest annual pace in about a year, a sharply above March's meager 0.8% rise. If there's an economic slowdown coming, as more than a few dismal scientists predicts, Joe Sixpack didn't receive word of that future in time to curtail borrowing in April. Perhaps a more reserved Joe will emerge in May's data.
Meantime, the consumer credit news had little impact on the bond market, although the yield on the 10-year Treasury did edge up a bit yesterday to close at about 5.03%. No matter, as the Fed funds futures market continues to hold fast to its recently revised prediction that another 25-basis-point rate hike is coming later this month.
But between now and the FOMC meeting on June 28/29 holds the potential for more than a little volatility as new data is released. Among the probable sources of revised thinking one way or another: next Wednesday's consumer price report for May; industrial production's update the day after; the latest on housing starts on June 20; durable goods on June 23; and existing home sales on June 27. And, of course, Mr. Bernanke may be inclined to talk publicly at some time between now and the end of June; given his recent history on chatting, we wouldn't underestimate his capacity to reformulate Wall Street's thinking yet again about the next step in monetary policy.
Yes, a 25-basis-point hike now seems likely. But tomorrow never knows. As the Beatle song recommends, "Turn off your mind, relax and float down stream...Lay down all thought, Surrender to the void." Sounds like a plan.
June 7, 2006
FROM HERE TO THERE
Now that inflation has been officially elevated to public enemy number one in central banking, courtesy of the Fed Chairman's chat on Monday, the debate over what forces, if any, might intervene to slow the monster's approach have begun in earnest. One school of thought argues that the economy will slow, thereby smothering inflationary fires before they have a chance to burn. But for those who think a slowdown offers hope on the inflation front, William Poole, president of the St. Louis Fed, suggests it may be time to reconsider that assumption.
"If inflation turns out to exceed ... our target range," Poole said in a Wall Street Journal (subscription required) story published today, "I do not believe we can count on a slowing economy to bring inflation down, by itself, quickly."
Of course, one might quibble over the definition of "quickly." Meanwhile, the jury's still out on whether inflation is in fact exceeding the target range, and by a meaningful margin that's more than fleeting. When it comes to finding a definitive answer, there's only the Bernanke prescription of waiting for more data.
Till then, the more pressing issue Poole raises is one of inflation remaining relatively high, if not rising, while the economy slows. The combination, if it proves durable, is hardly an encouraging prospect, raising the specter of the 1970s, a decade when the central banking proved to be something of a failure in delivering effective monetary policy.
But perceptions count for much when it comes to fighting inflation, and the battle has only just begun. Perhaps then we should take some comfort in seeing that the gold market is listening to the Fed heads and it likes what it's hearing. Indeed, the precious metal fell yesterday to near its lowest levels in about two months.
If the threat of higher inflation is real, why is the gold market selling off? One answer may be that gold, in addition to be an inflation hedge, is also a commodity and so in the short term it suffers all the usual effects that accompany speculation in other commodities. In other words, gold's merely correcting after a sharp upward spike.
But lest you think the metal's price signals all well on the inflation front, Citigroup analyst John Hill predicts that the bull market in gold is still intact. "We have been positive on gold for three years and expect it to ratchet much, much higher over time," he explains in a recent report, according to The Shanghai Daily via China View. "We would not be surprised to see a test of the old highs of US$850 an ounce."
Meanwhile, David Gitlitz, chief economist at TrendMacrolytics, reminded in a note to clients yesterday that price indices are "deeply lagging" and so they reflect yesterday's trend. Tomorrow's is another story, and on that matter the Fed is now signaling a desire to err on the side of caution.
The road to caution must first go through neutrality as it relates to monetary policy. And neutrality is still a ways off, reckons Brian Wesbury, chief economist of First Trust Advisors L.P. Writing today in an op-ed in the Wall Street Journal, he argues that a 6% Fed funds is probably closer to neutral at the moment.
Six percent is exactly 100 basis points above the current 5% Fed funds. Mr. Bernanke, it would seem, has his work cut out for him. The question is what will be the collateral damage between here and there?
June 6, 2006
HAWKISH COMMENTS DU JOUR
Mr. Bernanke can't seem to make up his mind in deciding if it's the season to promote the hawk or the dove when it comes to dropping hints about the future path of monetary policy. Perhaps we should blame the data. But if the economic and inflation signals lean toward volatility and random behavior these days, maybe the Fed chief should practice the now-ancient art of his predecessor: speaking in tongues. Failing that, there's always the foolproof skill that some refer to as buttoning one's lip.
Neither of which was in force yesterday, when Fed Chairman Bernanke spoke at Monday's International Monetary Conference in Washington. Among the more provocative comments dispensed yesterday by the central bank head was his observation that "...inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth."
In short, dear reader, the so-called pause in interest rate hikes, which Bernanke made a point of publicizing back on April 27, has been put on pause. Again. That is, at least until Mr. Bernanke gives another speech.
But if more attitude adjustment is approaching in the ongoing education of Ben Bernanke, the stock market wasn't inclined to wait around yesterday and see what comes next. The S&P 500 shed a hefty 1.7% yesterday, which, by most accounts, was triggered by Ben's latest opining. His remarks were also sufficiently pointed to move the 10-year Treasury yield back above 5.0%, after falling below that mark on Friday for the first time since May 24. And as for the recent hedged outlook for rate hikes at the June 28/29 FOMC meeting, traders of the Fed funds futures threw in the towel yesterday and decided to that another 25-basis point hike is coming, as per the selloff in the July contract.
To be fair, there's nothing wrong with a central banker expressing concern about inflationary pressures on the march. In fact, we prefer our Fed heads to err on the side of caution when it comes to containing any future seeds of higher inflation. It's far easier to drop interest rates to amend any hawkish error than it is to repair inflation-fighting credibility.
At the same time, consistency and prudence are worth something too when it comes to pronouncements from the mouth of the world's most influential banker. News flash to Mr. Bernanke: the world is poring over every syllable you utter, looking for monetary clues about the future that you may or may not have intended. As such, be careful--very, very careful.
At the risk of sounding impertinent, might we suggest to Mr. Bernanke that if you're view on inflation is evolving, shifting and otherwise running amuck, it's time to bend over backwards and communicate that point to the capital markets, which, of course, are in the habit of setting interest rates on the long end of the yield curve.
Granted, no one knows what's coming, not even the almighty Federal Reserve. But sometimes the future's fuzzier than usual. This is one of those times. Trying to encourage competing visions of clarity at such moments only risks trouble down the road when and if the data deliver contradictory news, as it's wont to do these days.
If the Fed chief continues to amend and change his tune, he risks losing credibility with the marketplace. That's a problem, a big problem, because to date he never really established credibility, having been on the job barely more than four months. In other words, he has precious little credibility to lose at the moment.
Stability and consistency, one might argue, should be the priorities in Fed communications at the moment. That's no easy task, to be sure, given the roller coaster that seems to define the economic news of late. But challenging or not, the Fed chairman's task is as much about managing perceptions as it is brandishing intellectual prowess, of which Bernanke has much. It's on the perceptions-management score, however, that he's stumbling. Rest assured, Mr. Market won't stand for any more slip-ups.
June 5, 2006
There are several possible explanations for the reported fall in Saudi Arabia's oil production in recent months. The official account is that the Kingdom is having a tough time finding buyers, according to the Saudi oil minister, Ali Naimi, via The Wall Street Journal (subscription required). In an interview after last week's Opec meeting in Venezuela, Naimi said that his country's crude production had fallen recently, which he says is a reflection of market conditions.
Nonetheless, when production slips in the world's largest source of proven oil reserves, there is chatter about what's really going on. Such is life in the pricing of a consumable good whose influence can hardly be overestimated on the global economy.
If Naimi's line is correct, it would corroborate the prediction by others that the U.S. economy is slowing. As the world's largest consumer of oil, even a marginal slump in America's appetite for crude would necessarily have repercussions for Saudi production.
But there are competing theories in defining reality in the marketplace for the world's most important commodity. For some, the slip in Saudi production of late is sure to give aid and support to the theory that a production peak is imminent in the Kingdom's output. Matthew Simmons detailed this perspective in last year's Twilight In The Desert: The Coming Saudi Oil Shock and the World Economy. Naimi's latest comments only promise to stir the debate over peaking as it relates to Saudi Arabia.
Definitive answers, alas, are hard to come by in the world of oil. Indeed, deciphering what's going on by watching prices alone remains as thorny a task as ever. Oil prices are at once a reflection of supply and demand forces and of geopolitical risk. Separating the influence of one from the other in an effort to recalculate the "true" economic price is more art than science.
With that in mind, it's not clear if the latest run higher in oil prices reflects the realities of Saudi production declines, heightened supply risks via Iran's latest threat to resuscitate the oil weapon, or some mix of the two along with all the other usual suspects that traditionally invigorate oil buying.
Whatever the reason, oil prices today moved above $73 a barrel in New York futures trading for the first time since May 15. The economy may be slowing, but it's debatable if such a stumble will ease inflationary pressures sooner rather than later. Meanwhile, the prospect of higher oil prices will no doubt find an attentive audience at the Federal Reserve this week, which is struggling over monetary policy at the moment, particularly as it relates to the next FOMC meeting on June 28 and 29.
For the moment, the July Fed funds futures contract is hedging its bets about whether another interest rate hike is coming. Perhaps the bigger question is whether monetary policy for the foreseeable future is destined to reside in the hands of Fed governors or in the offices of political leaders in Riyadh and Tehran by way of oil pricing?
June 2, 2006
DOES A STUMBLE MEAN A PAUSE?
June promises to be a month when Wall Street fully embraces the question: Is the economy slowing or isn't it?
The latest smoking gun suggesting that the economy is in fact slowing comes in this morning's jobs report for May, a release that shows the smallest monthly increase in nonfarm payrolls since last October's 37,000 advance, and well below the average monthly increase of 157,000 that's prevailed over the past two years, the Bureau of Labor Statistics reported.
One month is not a trend, of course, although a longer-term inclination is. Consider that the rolling 12-month percentage change in monthly nonfarm payrolls has been looking tired for some time. As our chart below illustrates, the 12-month change in job growth appears to have hit a ceiling of around 1.5% in the last two years and is now starting to drift lower. For May, the advance was 1.4%, unchanged from April's percentage rise.
Is this a sign of an economy that's starting to weaken? If so, how will the trend affect the Federal Reserve, when its FOMC convenes on June 28 and 29 to consider monetary policy anew? Yes, optimists will take heart in the news that May's unemployment rate fell to 4.6%, the lowest since July 2001. But the realization that May's job growth generally surprised economists with a weaker-than-expected report, plus the fact that April's growth was revised downward, is likely to take much of the shine off the lower jobless rate.
Josh Shapiro, chief economist at MFR Inc., told MarketWatch.com this morning that sluggish growth in the payroll report "muddies the waters" for the Fed's next confab on interest rates. "It is looking more like some sort of slowdown," he opines. "This could put the idea of pause [in further rate hikes] back in play."
Supporting Shapiro's analysis is the fact that wage growth slowed dramatically in May, which gives the Fed more room to argue that inflation pressures are waning and so a pause, temporary or otherwise, is warranted later this month. Average hourly earnings rose by just a penny last month. That's a sharp slowdown from the 10.3-cents average increase over the previous three months.
Traders of Fed funds futures needed no convincing this morning of the pause-is-back mentality. Buying of the July Fed funds futures contract soared in early trading today, pushing down the associated yield in the process. As we write, the contract is priced for a Fed funds of 5.11%. That's just about midway from the current 5.0% and the 5.25% that might be coming if the central bank opts for another hike on June 28/29.
Hedging one's bets, in fact, seems eminently reasonable for the moment. There are, after all, more than a few economic reports to be dispensed between now and June 28/29, and today's thinking about a pause may give way to something else. The month is still young, and so the opportunities for speculation still ripe. Welcome to a trader's paradise.
June 1, 2006
HANDICAPPING OIL'S SHORT-TERM OUTLOOK
As bull markets go, crude oil's run looks nearly perfect. Higher highs, and higher lows have dispensed a price history in recent years of unusual clarity. A more perfect scenario for a bull could hardly be imagined.
As you can see from the chart below (courtesy of the Energy Information Administration, as are all subsequent charts posted), the last two years of oil pricing have been a model of bullish behavior from a technical analyst's perspective. Every time a selloff arrived, it was but a temporary setback to even greater heights. Going long oil, in short, has so far been one of the great trades of the 21st century.
That, of course, is obvious to even a casual observer. What comes next, by contrast, remains the stuff of speculation. In an effort to make it informed speculation, we present the following analysis, starting with some macro context, which entails our belief that in the long run higher prices are likely to prevail. That outlook comes courtesy of the consequences that invariably spring from what we see as tightening supplies and rising demand.
The three variables that could upset our bullish forecast in the long run are geopolitical risks, an unexpected surge in global economic growth, and technology. The latter is the only one that's assured.
Technology, in one form or another, will intervene by delivering greater-than-expected supply. Make no mistake: everything from alternative fuels to improved means of extracting oil from the ground to enhanced efficiency in consumption will boost supply. Whether the associated supply is boosted to a degree that makes a material long-term impact on the global supply/demand equation is the question. Based on the data we've seen, our guess is a cautious "no." At best, the ability for technology to offset the realities of a maturing supply future in conventional oil is a huge guess. At worst, it falls far short of expectations in keeping a supply crunch at bay. As such, short of some extraordinary breakthrough that at present remains unknown, bullish forecasts for oil prices in the years and decades ahead seem eminently prudent.
It's all about Economics 101 in the oil game--in the long run. In the more immediate future, predictions become more unstable, and the primary contributor to this instability at the moment is the global economy, and the United States in particular.
Because the U.S. is by far the world's largest consumer of crude oil, changes in America's economic rate of growth will have more than a trivial impact on the price of oil. When and if the economy stumbles, something more than a temporary correction in oil market may arrive. Timing, of course, is the great question that can't be answered. But we can monitor the facts as they arrive, and draw some conclusions.
With that in mind, there may be clues about the future direction of oil prices embedded in the trend of U.S. oil supplies. As the chart below reveals, supplies (or stocks, as they're called in the trade) have been moving higher in relative and absolute terms. The oil companies serving the domestic market have been loading up on crude stocks in anticipation that demand will continue rising at a pace that's at least consistent with the recent past.
Perhaps, although as the next chart shows, demand for gasoline (the primary byproduct of crude oil) is showing signs of leveling off for the moment, which may be a prelude to price declines, albeit temporary.
Indeed, it's worth noting that operating capacity at U.S. refineries has recently been running significantly below the year-earlier rate. For the week ended this past May 19, for instance, refinery capacity utilization was running at 89.6%, significantly below the 93% rate in the same period from 2005, according to the Energy Information Administration.
Deciding if this all adds up to a long-lasting correction in the price of oil will likely turn on marginal changes in the rate of economic growth. Definitive conclusions, alas, arrive only with the benefit of hindsight. But with a growing number of economists predicting a slowdown in GDP's pace for the second half of this year, it's time to consider the implications for the price of oil.
The Energy Information Administration is doing no less. In a May 9 forecast of oil prices for next year, EIA's calls for an average price that remains more or less unchanged from this year. For the price of a commodity that's shown an inclination to materially rise in recent years, even when measured by the slow-moving average annual price, the EIA's latest outlook may be a sign of things to come.