http://www.gold-eagle.com/gold_digest_04/ci050104.htmlThe Character Of Slack...To suggest that the financial markets have been on heightened alert recently in terms of anticipating potential forward movement in the Fed Funds rate is an understatement. Moreover, in today's world, participants in the fixed income markets are more financially levered in aggregate than ever before. In all fairness, the markets have a perfect right to be worried about forward rates. Alternatively, we think it appropriate to take a broader look at economic "slack" at the moment relative to historical experience in an attempt to gauge the total picture the Fed may be contemplating as we speak. Although Greenspan has now stated that deflation concerns can officially rest in peace, and although absolute interest rate levels remain anomalistically low, will a few months of strong payroll gains or CPI readings push the Fed over the edge into the beginnings of a significant and prolonged rate tightening cycle? And although this is clearly a topic for an entire discussion, it is important to remember that the markets look ahead. By the time the Fed gets around to actually beginning to physically raise the Fed Funds rate, the markets will have already discounted the beginning of this process. In fact, it seems more than clear that this discounting is underway right now. Ultimately, speed and magnitude of rate increases remain the important unknowns in our mind. Hence, our belief that the historical "character of slack" will ultimately determine, or help determine, the speed and magnitude of what is to be the inevitability of the Fed response ahead. Clearly important both for equity and fixed income markets near term. For the purposes of the following discussion, we will not be addressing important issues that can and do influence interest rate movements such as currency differentials and global flows of capital. The following is purely fundamental economic statistics of the moment relative to historical experience as it applies to the initiation of Fed Funds tightening cycles of the past.
big snip>
The Rating Game...Certainly the collective numbers above cannot be viewed in isolation. If they were to be viewed as such, we would be concluding that there will be no hiking of the Fed Funds rate anytime soon based on the current character of employment, production, utilization, wage gains and headline inflation readings. BUT, and this is a big but, it virtually goes without saying that the current broader financial and economic landscape is truly unlike anything we have seen anywhere over the last forty years at least. We continue to wander through a post equity bubble environment that is characterized by an unprecedented credit cycle accompanied by unprecedented fiscal and monetary stimulus. Our current economic "recovery" is anything but what might be termed normal looking back at post recessionary periods of the last half century at least. The perhaps unintended consequences of Fed and administration actions over the past three to four years has borne fruit in record fixed income market leverage, multi-decade rate of change highs in housing price inflation, record levels of household leverage, and spiking global commodity prices over the last few years. Lastly, it is totally clear to US that the Fed made an all or none bet in lowering the Funds rate to 1% and implicitly encouraging the systemic growth of leverage. As we have mentioned many a time, we simply do not know how they can gracefully retrace their steps while expecting highly levered asset markets really globally to remain calm or subdued. Is this exact thought just what the markets have started to realize over the past month or so? Although we certainly lived through a bit of this last year with the rise in 10 year Treasury yields from near 3.1% to approximately 4.6% in mid-summer, it sure appears that for the second time in twelve months, the US bond market is calling the Fed's bluff.
In looking back over Fed tightening experience of the last four decades at least, as we mentioned, it is clear that there were a distinct number of aborted interest rate tightening cycles. Periods where the Fed began to raise rates only to meet up with an economy showing relatively immediate anecdotal signs of rolling over. Tightening cycles of 1971, 1976 and 1986 are clear in their short lived message. But in our minds, a potential near term initiation of a Funds rate tightening cycle ahead may have a lot less to do with slowing a runaway real economy than it will have to do with a Fed being dragged into action by a market finally recognizing, reacting to, and pricing in the consequences of profligate monetary and fiscal policy decisions that have been compounding for years. Policy decisions whose intended or unintended consequences can no longer be ignored by either domestic or international investors.
Recently in the subscriber portion of the site, we penned a discussion regarding the bond market "vigilantes". Our suggestion was that the vigilantes of yesteryear have been replaced by the global fixed income highwaymen of the moment - the carry trade crowd, the large interest rate swap derivatives players, and the global currency intervention cowboys. Much like last summer, there is no question in our minds that a good portion of the backup in Treasury yields we are now seeing is the direct result of a larger unwinding of leverage, especially among the carry trade folks and the derivatives aficionados. Of course it's easy for the mainstream media to suggest bond market machinations of the moment are the direct result of an explosion in payroll gains and heightened inflation alert. It's a wonderful cover. But the character of system-wide economic slack described above suggests the changing nature of perceptions regarding structural leverage in the system may have a lot more to do with the current directional momentum in rates than does the real economy. Although it may sound like a toss away comment, isn't it fairly obvious that one of the most levered economic environments in history would hit a growth rate brick wall if interest rates were to rise meaningfully? An economy that has become addicted to credit isn't going to run even faster when the dosage of its primary stimulant has been reduced. Even as the Fed eventually reacts to where the market is obviously leading it at the moment, will we ultimately witness yet another of history's aborted Fed Funds tightening cycles? Or will it be something a bit worse? Of course only time will tell, but history suggests that meaningful tightening in the current environment of real economic slack relative to historical experience will stop economic growth dead in its tracks. The irony, of course, is that by betting the ranch with anomalistic monetary policy over the last three to four years, the Fed has put themselves in a box. To get out of the box, they necessarily will have to at least in part puncture the credit dependent economy they helped foster in the first place. And certainly this should not be unexpected or some type of surprise. The build up in systemic leverage has been clearly documented in each Fed Flow of Funds quarterly report for years. In all sincerity, we take no pleasure at all in seeing a real economy exhibiting so much slack relative to historical post recessionary experience at what appears the exact time the markets are likely to force the Fed to deal with the unintended consequences of their remarkable actions of the recent past. We all face judgment day at some point, now don't we?
Printer-friendly format
Email this thread to a friend
Bookmark this thread
(1000+ posts)
Send PM |
Profile |
Ignore
|
|
