Tuesday, August 14, 2007

Creditability is on the Table for the Fed’s Taking

FOMC Report
August 7, 2007
Creditability is on the Table for the Fed’s Taking

Martin McGuire

There are a number of ways the current situation may play out. Consider the extreme in risk appetite: brought on by a false sense of security - resulting from the `new and more transparent' Fed - supported a growth in excess liquidity at a time when this same august department was proclaiming they were administering a restrictive policy initiative. There is a first for everything. I cannot personally recollect a time until most recently, when an investor was told point plank by the Federal Reserve what his borrowing costs, both in duration between and the amount of incremental adjustments, would be along a time line. It is really quite incredible that anyone would have envisioned anything but a pronounced increase in risk appetite which would drive credit spreads tighter the worldover following a supposed restrictive monetary policy which simply postponed the Feds work for another day.
Frankly, I don't know how it was that the Fed got this one so wrong. Restrictive monetary policy is a tool used to cull risk appetite. In accelerating its adventure in bringing transparency to their efforts during a restrictive policy directive, the Fed negated much of the historic benefit of risk appetite suppressant which normally accompanied similar policy shifts in the past. As I have long argued, transparency works well on only one of the Feds dual mandates. Transparency can benefit efforts in promoting economic growth, but can do little to aid inflation containment.
An initial move toward a more restrictive policy stance, whether indicated by an initial rate adjustment or a series therein would historically bring about a massive adjustment in the perception of the benefit in extending oneself beyond immediately identifiable, productive employment of available resources. In short, the Fed of old wielded the power to truncate excess risk appetite. It did so by walking softly while carrying a big stick. Instead of tamping on risk appetite and reducing excess liquidity, the Fed instead encouraged risk assumption. As a result of the increased transparency, the Fed also insured that the lag time between the Feds restrictive policy initiatives and their impact on the economy would be much longer than ever before. The more historic reaction function toward economic and financial market response to the Fed's restrictive policy initiatives would be pushed out further in time. It has been 14 months since the Fed last raised rates. It has been 38 month since June 30, ’04 when the Fed first began raising rates. While it was once was thought to take 9-18 months on the outside for restrictive monetary policy measures to work their way through the system, the response to the most recent restrictive policy directive has taken over twice as long to have an impact.
I have discussed at length the reason for and the implications of the delayed market
response to the Feds restrictive policy initiatives when its goal toward transparency was held as importantly as it has been. You can see some of this work by looking at my blog: The Fed and Interest Rates . I would be willing to share more dated reports to those interested.

Few can be as delighted as I in the way the market has traded since the last FOMC
meeting. With the Congressional testimony forthcoming, it appeared that Mr. Bernanke
and the other FOMC members would lean toward even-handedness with a continued
emphasis on risk weighted toward higher inflation (when they issued their statement
following the June 27-28 FOMC meeting). There was then little reason coming into that
meeting to expect any appreciable change in the statement language which would follow.
Because economic reports had been slightly stronger than market expectations on the
approach of the June meeting, I brought a more balanced outlook for the intra-meeting
period that just ended. While my base case argued for weaker economic prospects: ‘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.’ I understood how an up-tic in inflation could be a potential Fed trigger for higher rates forthcoming, so I cautioned: ‘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.’
The main argument I made was that there was little reason to believe that the Fed would ‘fine-tune’ monetary policy. I had very strongly advised clients that should the market prove willing and able to price in one full Fed Funds rate adjustment of 25 basis points, it would rather quickly move to price in nearly three rate adjustments in the same direction. The simplicity of that statement may not have properly conveyed the potential for gain when ‘theory is put into practice’. There was indeed a rather quick unfolding of expected developments when the market proved willing and able to price in one complete rate move (namely an ease by settling above 94.885 (100-(Current Fed Funds Target Rate - 25 basis points +11.5 basis points (for 3 month libor over Fed Funds Target Rate))). On July 20th after 5 separate attempts and failures to settle above 9488.5 (including one attempt on the first day of the last FOMC meeting-June 27), EDU8 settled to 94.91. It maintained settlement above 9488.5 over the next three sessions as few considered the significance of this development. On July 26, only 4 business days since EDU8 first successfully vaulted one rate move, EDU8 exploded to the upside to capture a 17.5 basis point session gain to 9514.5 (more than 2 eases of 25 priced). Early yesterday on the morning of August 6, EDU8 traded to 9533.5 within 5 basis points of pricing in 75 basis points (three rate moves).
There may be more financial dislocation forthcoming. Mr. Bernanke may tip his hat to
this recent dislocation, but I believe the amount of creditability to be gained from
maintaining a risk weighting toward higher inflation is too precious to leave on the table.
Frankly, the Fed has put the market where it is. The amount of excess liquidity, which had helped to force credit spreads tight, was their own doing. The Fed is therefore responsible for sorting this out. The economy has had a longer run that it should have because too many dollars were chasing too many SUV’s, homes and ethanol. Allow me to digress very briefly by restating my definition of excess liquidity: Excess liquidity is the monies left when all viable economic enterprise is fully subscribed. These monies will find a home, but it is never a permanent home and it will only find a more lasting address when the market inadvertently punishes a viable economic enterprise to a point where subscription here again makes economic sense. The time for more moderate risk assumption is upon us and the Fed cannot sponsor any rescue plan at the moment. If the Fed is to ‘come to the rescue’ any time soon without a complete freeze-up of the credit markets, they will be sending a message that will have lasting and negative implications for inflation. The dollar will suffer terribly if the Fed moves at this time. The dollar index is only a breath away from all time lows and an overly reactive monetary policy response to recent financial dislocation could help to push the dollar over the edge.

I have been in the camp for the Fed to move rates lower at the September 18th meeting for many months and believe this a real possibility. However, it needs to come on the heels of real economic slowing and not on the hype of hysterical headlines. A deceleration in economic growth has been later in arriving than I had expected. The signs however, are growing that employment conditions are softening. Three of the last four employment releases have been accompanied by lower revisions to prior reports. I suspect the birth/death add-ons to the employment numbers are going to have less of a buoying effect going forward. If you want to know how the statement following today’s FOMC meeting is likely to read, ask yourself what is it the Fed can say that would bring the most calm to the market as a whole? If you truly believe the Fed brings a greater sense of calm by indicating that recent unrest in the financial markets coupled with the knock-on effects from tighter credit standards has negatively impacted the prospects for continued growth at or near the economies long-run potential and therefore, without an appropriate monetary response the prospects are expected to continue to deteriorate; then certainly you would want to be long EDU8 and two year Treasuries. Conversely, if you believe the Fed when it has repeatedly stated that its is operating a forecast-based monetary policy directive, then you must agree that the extent to which the Fed responds to recent financial market distress is driven solely by their expectation for a response in real economic activity. Should the Fed expect economic growth to slacken more substantially and more lastingly in response to tighter credit conditions, they will change their economic forecast and possibly their monetary policy. Otherwise, onward we shall march until the forward looking economic picture as presented by a continued series of forthcoming economic data paints a different landscape. And it will. Yes, it will.

An Aside:
It is very easy for us financial types to see things so clearly from a financial market perspective. By now, there are probably very few people in our business who don’t know of someone who has lost their job and you probably know a few who are ‘on the bubble’. Not long ago, I had frequent conversations with some very smart people in New York at one particular global money center bank. I would warn of the dire nature of the housing market and the longer implications of these developments. However, we had differing frames of references. They saw the price of downtown condos continue to ratchet up and for the price of homes in near-by suburbs continue to command premium prices. I saw initiated, but abandoned building projects.
What we both failed to consider adequately at the time was that one of the main reasons NY and some other major metro areas decoupled from the national housing market was a willingness to extrapolate the tightness in a particular ‘skilled labor’ in those areas.
Specifically, the skill most in demand was money management expertise. There was a
need to find ‘investments’ for all the excess liquidity. The salaries of money managers got bid up and the homes they were able to afford rose as well. Now that there is less need for help with finding a home for excess liquidity, simply because there is less of it about, the salaries and home prices in these areas should also come back to Earth.

Current Fed Rate Expectations:
FOMC Date Funds Target Risk Assessment
August 7, 2007 | 5.25% | OK Eco-Hi 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
March 18, 2008 | 5.25% | Balanced

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