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.

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.

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.

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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.

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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.

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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.

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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.

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What Mr. Market giveth, he also taketh away. That was mostly true for this month, as the chart below documents. The high-flying asset classes were generally the ones that suffered the most in May, as of yesterday’s closing prices.
The primary exception was commodities. A high-flying asset of late, by any measure, but one that also led the pack in producing what was otherwise in short supply in May: robust positive returns.
Our measure of commodities is the PIMCO Commodity Real Return Strategy fund, which tracks the Dow Jones-AIG Commodity Index. By this gauge, May was in fact merry, with the mutual fund advancing 1.95% for the month.
On the opposite end of the performance spectrum is the sharp loss for emerging markets stocks, which retreated by 12.6% this month through yesterday, measured here by the iShares MSCI Emerging Markets ETF. But even that deep cut has yet to knock the asset class from its perch as the best performer over the past year. Emerging markets equities may be suffering these days, but in the race over the past 12 months they’re still far and away the top dog.
The question, of course, is what comes next, and on that score there is always far less clarity compared with dissecting what’s just passed. In any case, perhaps this is a timely moment for a strategically minded investor to ask if momentum has legs in bear as well as bull markets.

Asset class proxies: Vanguard REIT Index VIPER, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov’t Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities, PIMCO Commodity Real Return Strategy.

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Mr. Market has been wearing optimism on his sleeve when it comes to estimating the future path of inflation by way of the spread between nominal and inflation-indexed Treasuries with 10-year maturities. But the optimism that has been fashionable this season past may fall out of favor this summer as inflation fears heat up.
As of last week’s close, the nominal yield on a 10-year Treasury was 5.06%, according to the databank maintained by the U.S. Treasury. The 10-year inflation-indexed Treasury (or 10-year TIPS, as everyone likes to call them) ended the week at 2.44%. The spread between the two was 2.62% (5.06 less 2.44). In other words, Mr. Market’s forecast of inflation is 2.62%, as the chart below illustrates.

How high is 2.62% as an inflation forecast? Arguably, not high enough, even though it represents the upper range based on the last three years, and up about 30 basis points from 2005’s close. But on one level, at least, 2.62% as an inflation expectation appears more than a little dovish. We come to the conclusion by pointing out that 2.62% is considerably below the 3.5% current annual pace of increase in consumer prices.

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