Thursday, June 28, 2007

Theory Into Practice

FOMC Report
June 27-28, 2007

Theory into Practice

Martin McGuire

Turning Theory into Practice:

Theory is nice as a concept and looks good in books on the shelf, but practical application is the driving force behind its creation. Through these FOMC reports, I have brought to you some larger scope concepts which I hope have helped you discover your own expectations for market, economic and monetary policy prospects. This time I will try to concentrate more on practical application.

Following the pause in the ‘path-dependent restrictive monetary policy directive,’ which ended after 17 well orchestrated and anticipated 25 basis point rate hikes, I suggested that if and when the Fed moved to adjust the Fed Funds target policy rate, it would do so in a series of three moves. Fewer rate adjustments would have looked rather meaningless compared to the prior adjustment. Greater efforts may have prompted market participants to price in much more than the Fed had in mind.

My base case is for weaker employment, slower consumer spending, continued fall-out from over-lending in the housing industry, delayed but still forthcoming impact from prior rate hikes and cyclically declining inflation prospects; all adding up to a greater likelihood for the next monetary policy shift to be toward lower rates. Conversely, the prospects for excess liquidity, which has largely confined itself to impacting asset prices, might begin to impact prices at the consumer level. Should this happen or the threat of such appear real enough, the Fed will respond by raising rates.

There will be forthcoming data which tilts the scales toward one of the above scenarios becoming more likely. There may not be enough in a piece of economic data or a series therein to convince market participants a complete rate move should be priced. In fact, it should be very hard at this point to convince market participants overwhelmingly that the market should price in a full rate move. If the market is certain the Fed will move at all, it will price in the prospects for a series of rate moves for a ‘full adjustment’ rather than a mere fine-tuning.

This is where I get to the gem. I hope I have not lost you yet. There are many ways to profitably apply this theory. First, we can fade all moves which approach the pricing of one rate move and wait to take the opposite action on the return to neutrality priced. We do this because we believe that it will be very hard to convince the majority that the Fed is ready to embark on a re-pricing of the target rate. Such a strategy would be successful if market participants in general gave up on efforts to price in a rate move and prices moved back toward neutral where the position would be removed. Note that I am being very careful here not to indicate direction; it works both ways.

Second, we can initiate positions as the market, at or near a neutral Fed pricing, starts to move away from neutral and toward pricing a rate move. This strategy would attempt to take advantage of a bit of momentum within the 50 basis point range. It would prove successful if, after obtaining a position, price action would continue to move toward pricing in one rate move; at which point the position would be removed.

Third, we could own a straddle with strikes consistent with the pricing of no Fed rate move and play the ‘noise’ for the back and forth (within the 50 basis point range which describes one rate move in either direction) that will accompany conflicting economic data. With such a strategy, we would be charged with delta hedging the frequent intra-range moves to capture gains.

Fourth, a position can be taken which would benefit from a move outside the expected range (own strangles). This would benefit from expected momentum as the market priced in a full rate adjustment rather than a fine-tuning. On a confirmed move outside the 50 basis point range surrounding a neutral Fed, we would expect momentum to propel trade toward the extreme of three rate moves priced.

Piece de resistance: If and when price action nears one of the extremes of three rate moves priced (9388.5 or 9538.5), we should begin to take profits and take positions which would benefit from a pause in the rate moves. One approach would be to sell out-of-money strike calls on a move toward 9538.5 and/or sell out-of-the money strike puts on a move toward 9388.5.

Finally, an approach which requires the greatest amount of patience and is likely to generate the greatest revenues, should it happen, is to position for the move between one rate move priced and three rate moves priced, but only initiate this once a full rate move has been priced. This is the least active approach and it can and should be used in conjuncture with any of the above strategies. The other approaches allow us to keep busy in a market which might otherwise drive sane traders toward some other less desirable mental state.

You may be saying to yourself that this is a widely read report (he humbly suggests) and it is eventually posted on the web at . There is then a chance that some well financed concerns drive prices through one of these ‘one- rate-move’ pricing points to take advantage of those stepping in for a momentum trade. To that, I say it is an art and not a science. This is a great theory and I believe it will prove profitable in practice. Frankly, it already has. I would be delighted to advise those clients interested in my thoughts on the approach or besting of the aforementioned critical levels.

Below is a chart that illustrates the above:

Bullet Points:

1.) I think the next Fed move is an ease. So what! It could go either way. This is the challenge. We don’t know and neither does the Fed. Transparency is for naught.
2.) If there is to be any near-term (within 6 months) reduction in the Fed’s target rate, it is increasingly more likely to come as a result of financial market dislocation. Conversely, if a rate hike is in order, it will come from liquidity turned into inflation.
3.) A normal yield curve is a good thing. It reminds people there is greater risk to holding investments for longer than overnight.
4.) Recent wider yield spreads along the curve are not an expression of expectations for significantly stronger economic growth.
5.) Higher yielding long-term treasuries raise the bar on an array of asset classes.
6.) Credit spreads are tight because there are few remaining economically viable alternatives for excess liquidity.
7.) Private equity efforts, mergers and acquisitions and share buyback of late are illustrations of non-productive expenditures that further illustrate my sixth point.
8.) Ben Bernanke and the FOMC have done a great job thus far.
9.) They had it wrong providing all the guidance during the restrictive policy initiative unless they endeavored to create excess liquidity. Restrictive monetary policy efforts should generally be designed to curb rampant speculation, not create it.
10.) Inflation targeting is a bullet best left in the chamber. Certainly it should not be spent unless creditability is seriously damaged.
11.) Growth in Europe is not going to be enough to keep the U.S. economy near potential through exports.
12.) The consumer will continue to tire of spending beyond his means
13.) While corporate balance sheets look good and financial conditions are still supportive, corporate concerns do not come to the rescue when consumers take a break from spending.
14.) Greenspan has great timing. The longer the liquidity bubble he helped create lasts, the less he gets paid for speeches—quite likely the reason he took a consulting job at Pimco.
15.) The labor market is not as strong as suggested by the non-farm payroll numbers of the last 5 months. Time and lagged revisions will prove this out, as in ’03 reverse-wise.
16.) The definition of a ‘skilled-worker’ is one who if hired, allows the employer to fire two less-skilled workers.
17.) Mr. Bernanke spoke of a trend when he stated there had been a ‘gradual ebbing’ in core inflation. Now all we have to do is figure out how strong a trend.
17.) Jesus Saves! American consumers are eventually going to have to re-learn how to.
18.) The Fed is pleased to have a normalized curve to help with the job of curbing excess speculation.
19.) Excess liquidity is defined as an amount of liquid assets left after all economically viable investments are fully subscribed.
20.) Enough bullet points.

Current Fed Rate Expectations:

FOMC Date Funds Target Risk Assessment

June 27-28, 2007 5.25% OK Eco-Hi Infla
August 7, 2007 5.25% Slow Eco-OK Infla
September 18, 2007 5.00% Slow Eco-Low Infla
October 30-31, 2007 4.75% Slow Eco-Low Infla
December 11, 2007 4.50% Balanced
January, 2008 4.50% Balanced


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