Tuesday, March 27, 2007

A Different Policy Cycle

FOMC Report
January 30-31, 2007

A Different Policy Cycle

Martin McGuire


There is little left of the 75+ basis point of ease the market was pricing for year end 07’ when the FOMC last met in December. Liquidity is not easily drained when the Fed lays out its intentions in a ‘path-dependent restrictive policy directive’. Credit spreads remain historically tight and M2 growth is above the Feds projected cone leaving Fed officials uneasy about their stated expectations for continued easing of inflation pressures. The Feds policy pause has held longer than the average of 6.2 months between the last rate hike and the first rate ease in the past three policy cycles. Baring any shocks, the Fed is expected to remain on hold until the May FOMC meeting when it institutes the first of three consecutive 25 basis point eases.

Present Conditions

It has been 7 months since the Fed last raised rates at the June 06’ FOMC meeting. Long before the Fed initiated the first of 17 rate increases back in 04’ I had calculated the length of time between the Fed’s last rate hike and the first rate ease over the last three policy cycles as being 6.2 months. Based on the way U.S. fixed income has traded until December, this timing was expected to prevail once again as market participants marked down forward rates in anticipation of a similar policy cycle this time around.

Much of the ease which the market had priced has been removed over the period following the last FOMC meeting in December. Today, there is but scant probability priced for an ease by mid-year and only a 50% chance of an ease priced by years end.

M2 is up 5.1% yoy, above the high end of the Feds expectation. Junk bond yields are a mere 260 basis point over U.S. Treasuries when the average is closer to 5.20 over the last years. Finally, labor market data continues to indicate tightness while overall output continues to show solid readings despite weakness in housing and autos industries.

A Different Policy Cycle

A restrictive policy directive has a much different reaction function when the path and pace of the policy directive is clearly understood by all. In times past, only the direction of policy was understood by Fed watchers and there was rarely a unanimous consensus on these judgments. Having decided to be more transparent, the Fed, along with everyone else, is learning how market participants will react to a more forthcoming Fed.

The message from Fed officials has been largely consistent over the period following the completion of the ‘path-dependent restrictive policy directive’ which ended in June 06’. Even prior to the pause in rate hikes the Fed has made clear that they viewed the prospects for higher inflation as the overriding concern. The Fed has made extraordinary efforts designed to contain inflation expectations. These efforts will no doubt pay dividends going forward.

Currently however, the Fed may have greater reason to doubt earlier expectations that inflation pressure would abate along with economic growth slightly below potential. Immediately following the decision to hold the target rate steady after the last hike at June FOMC meeting, many economic variables began or continued to flash warnings of slower economic growth. While it was expected that the stubbornly high inflation readings would recede in time, in the absence of more dramatic and timely declines in inflation readings, Fed officials patience may be tiring.

From Dec FOMC Meeting to Now…What Happened?

In the week before the last meeting, the fifth rolling Eurodollar future had just traded to new high levels not seen for 16 months. Since then Eurodollars have gone from pricing in more than 75 basis points of ease with a Fed Funds rate of 4.35% in Dec 07 to removing nearly all of those expectations and pricing Fed Funds for 5.08% at year end.

What then has prompted this reversal? First, it was widely held that the Fed would ease roughly six months following the last tightening, thus following the course of the prior three rate cycle periods.

While I had expected greater volatility in price action once the Fed moved away from a ‘path-dependent policy directive’ to a more neutral setting, I am surprised by the swings in positions held by CFTC described ‘non-commercial accounts’.

Large spec. accounts held a record 668K in net short Eurodollar futures and options in June after the Fed’s last rate hike. From that point these account types built net long positions to a three year high net long of 555K as of the December FOMC meeting, an amazing swing of 1.22 million contracts over a 6 month period. Even more striking has been the swing in positions in the period from the December meeting to last Tuesday. Over that period, large spec. accounts have moved from a net long of 555K to a net short of 363K. In other words, these account types reversed in six weeks over 75 percent of a position it took them six months to build. The pace of that position shift by these account types is unprecedented.

Why the Fed Can’t Get on with the Job of Easing Rates:

If the Fed’s next move is to tighten rather than ease, the one culprit we should point to would be excess liquidity. I have long been warned by those in a position to know that liquidity is excessive to the extreme. Their warnings remind me of a scene from the movie ‘Pretty Woman’ when Julia Roberts is shopping and the attendant asks Richard Gere ‘Just how obscene an amount of cash are we talking about here? Profane or really offensive?’ The response by Gere of course was ‘Really offensive.’ Really offensive is how some of my friends have been describing the market liquidity. They argue it is because of this liquidity that the Fed could not possibly ease but instead should be expected to tighten its policy stance.

Mergers and acquisitions are accelerating as are corporate equity buying backs. The acquisition of a rival firm does not add to capacity, but rather transfers ownership and puts funds back into the hands of the owners of the purchased firm. These prior owners are then forced to go back to the market to find productive enterprise for their new found liquid state.

Likewise, a buyback program returns funds to shareholders who find the price the firm is willing to pay too high to ignore. These would be shareholders are then forced to look into the financial market place for investments.

All this while, Asian central banks add to their holding of U.S. treasuries which helps keep treasury rates lower than they would otherwise be thus artificially lowering the hurdle rate on loanable funds. In addition, U.S. treasury purchases by nation/states flush with petro-dollars as well are not so rate sensitive as they are in need for a place to park these funds. These concerns then advance an arena where speculative excess is more prone to take place.

The Fed fights asset bubbles only at the margin. For an economy to grow at its long-run potential a certain level of funding/liquidity is necessary. By helping to insure there is not too much in excess of the needed funds to support economic growth at the long-run potential, the Fed limits the amount of funds which would make their way more easily to non-economic enterprise (bubbles). The Fed may be concerned that they have as yet not done enough to insure there are only enough funds available to allow for the long-run potential economic growth, but rather allowed an excess of the necessary funding to remain available.

Tight credit spreads, excess liquidity and M2 growth above the Fed targeted cone does not normally follow a restrictive policy directive which saw target rates rise 4.25%. In fact, in spite of a significant contraction in the housing market, financial conditions by nearly all accounts are still quite friendly toward speculation.

While many signals indicate the need for continued or increased Fed vigilance, I continue to suspect that the lagged effect from prior rate hikes will begin to have a more meaningful impact now that the Fed is no longer in a ‘path-dependent policy directive’. Therefore baring any shocks, I would push forward my expectation for a rate ease to May. Any slowing in the pace of progress in inflation reading moving toward the Feds comfort zone of 1-2% would put a renewed restrictive policy directive on the table.

Current Six Meeting Forecast for Fed Funds Target:

FOMC Date Funds Target Risk Assessment

January 30-31, 07’ 5.25% Tightening Bias
March 20-21, 07’ 5.25% Balanced
May 9, 07’ 5.00% Slow Eco-Low Infla
June 27-28, 07’ 4.75% Slow Eco-Low Infla
August 7, 07’ 4.50% Bal-Low Inflation September 18, 07’ 4.50% Balanced


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