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The Fed's Cunundrum

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Old February 22nd 05, 08:39 PM
Ron Yair
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Default The Fed's Cunundrum

February, 18th, 2005
The Fed's Conundrum

by Ron Yair

The Federal Reserve has been raising rates since last June. In that
period the federal funds rate has increased from 1.00% to 2.50%. More
increases are almost certain to follow at the upcoming meetings, which
will push the fed funds rate to 3.00% and beyond. The Fed appears well
on its way to removing the inappropriate level of accommodation,
sticking to its "measured pace".
This seems appropriate given the steady growth rate of the economy and
reasonably well-behaved inflation. But the question is: Are monetary
conditions more restrictive than last June? I would argue no. During
that same period ten-year swap rates have fallen by 55 bps from 5.18%
on June 29 (the day before the first hike) to its current level of
4.63%. The ten-year swap rate exerts a greater influence on business
investment spending and major consumer purchases - such as housing -
through its role in determining mortgage rates.
In fact, Alan Greenspan spent a good portion of his semiannual
testimony to Congress this week discussing this very subject. The
issue for the Fed is that, in a sense, they only influence monetary
conditions, rather than control them through the administration of
market operations to achieve the targeted fed funds rate. While
Greenspan tried unsuccessfully to understand/explain why long rates
have fallen at the same time short rates have risen, the underlying
message was clear:
Long rates need to go higher for monetary conditions to becomes less
accommodative and prevent a buildup of inflationary pressures. And the
Fed will keep raising rates until that occurs. Paradoxically, the
slower that long-term rates rise in response to increases in the fed
funds rate and other forces, the more aggressive the Fed might be, and
the higher short rates may ultimately go.
Pushing on a string was a phrase that was in vogue in the early
nineties when the Fed's concerns were the mirror opposite of today.
It was coined to underscore the concept that the administration of
monetary policy is but one influence on overall monetary conditions.
If they are fighting against powerful market forces that run counter to
their objectives, changes in the fed funds rate will most likely have
negligible impact. Back then, the Fed cut the fed funds rate from
8.25% in July 1990 to 3.00% in September 1992. Despite the
extraordinary amount of easing to what was a new and unthinkable low
(at the time), the economy did not respond. Fed funds wound up
remaining at 3.00% for the next seventeen months, until the Fed began
tightening once again. Non-farm payrolls languished, averaging
negative 33,000 per month over the period from June 1990 to September
This largely had to do with the fact that long rates stayed stubbornly
high, leading to a very steep yield curve (see chart). When the Fed
started cutting rates in July 1990, the fed funds rate was 8.25% and
the 10-year swap rate was 9.25% - a differential of 100 bps. By April
1992 the fed funds rate was all the way down to 3.75%, but the 10-year
swap rate had fallen only by 131 bps to 7.94% (a differential of 419
bps). The economy continued to languish, as evidenced by the anemic
job creation numbers.
The Fed, surely frustrated by its inability to move long rates lower,
did the only thing it could: It continued to cut the funds rate
another 75 bps over the next 5 months down to 3.00%. But as of
November 1992, the 10-year swap still stood at a relatively restrictive
7.30%. As a result job growth averaged less than 100,000 per month for
1992. Then a huge bull flattening rally drove the 10-year swap rate
all the way down to 5.51% by September 1993, while fed funds remained
unchanged at 3.00%. This is what provided the monetary stimulus to
cause payroll growth to exceed 200,000 and 300,000 per month in 1993
and 1994, respectively.

What is the Yield Curve Telling Us Now?

The current situation is the reverse of the early nineties in terms of
direction. Now the Fed is attempting to extricate itself from and
extended period of monetary accommodation in which it kept fed funds at
1.00% for a full year to ward off the deflation demons. Having
achieved this, and sensing that the economy is on a self-sustaining
growth path, they have steadily increased the fed funds rate to its
current 2.50%.
But, as noted above, longer rates have simultaneously fallen, with the
10-year treasury briefly falling under 4.00% earlier this month. This
has kept mortgage rates near the lows seen for this cycle.
As a result housing starts were at a 31-year high last month, which
should continue to support consumer spending through the multiplier
effect as people furnish them. Business investment also continues at a
good clip. Coupled with a drop in productivity growth and weaker
dollar, there are concerns that the potential for inflation to increase
over time. But if one were looking for signs of inflation worries in
the financial markets, it would hard to find. In fact, as Greenspan
noted, longer-dated forwards have dropped even more that the 10-year
rate, implying a more sanguine long-term outlook for inflation. Part
of this has been due to a fall in risk premiums/spreads. But the bulk
is due to a drop in forward treasury (risk-less) yields. One can cite
a number of factors, including the enormous purchases of treasuries by
central banks investing their dollar reserves and lower long-term
yields in overseas bond markets. Lower long-term interest rates can
often be interpreted as an implicit market forecast of an economic
slowdown or lower inflation expectations. But if one were looking for
signs of corroboration, they would be hard to find. Equity markets,
Treasury Inflation Protected Securities (TIPS) and other measures do
not point to any large reassessment of future inflation expectations.
Most of the time, the market leads the Fed in terms of anticipating and
implementing a change in monetary conditions. For instance, the bond
market will generally sell off well in advance of an initial tightening
move, and forward rates will reflect the consensus estimate of where
fed funds and other short-term rates will be. When the Fed actually
moves it is most often a non-event as the Fed is just validating what
the market already knows. This has become especially true with the
Fed's move towards greater transparency. However, where Greenspan has
earned his legacy is by consistently predicting economic cycles and
trends. In fact, in some cases where the Fed seems to be following the
market's lead, it can be argued that the Fed led the way by
"jawboning" the market in the desired direction beforehand. In
other cases Greenspan has gone counter to the market consensus and,
more often than not, been proved correct.
This may be another one of those cases.
In his testimony on Tuesday he led off by saying "... the real
federal funds rate by most measures remains fairly low." Later on in
his prepared text he goes as far as opining: "Bond price movements
may be a short-term aberration, but it will be some time before we are
able to better judge the forces underlying recent experience." This
is about as clear a statement that he can make about the level of
discomfort the Fed has about current long-term rates and the direction
they would like them to move. One last quote from Mr. Greenspan to
underline this point: "If you understood what I said, I must have
misspoken." (From the archives.)


Monetary conditions remain overly accommodative given the current
growth trajectory and inflation risks. One potential warning sign was
the 0.8% month on month increase in the core PPI that printed today.
This appears to be the view of Greenspan as well. The implication is
that it is a question of when, not if, long-term rates will rise enough
to tighten conditions to a more appropriate level. It seems a safe bet
the Fed will keep on tightening until that occurs.
The more interesting scenario might be one in which the long-end sells
off in a bear steepener, allowing the Fed to keep moving at a measured
pace, as opposed to having to force the action by more aggressive
moves. Going back to the pushing on a string analogy: If this is the
mirror image of the early nineties, then the Fed can be considered to
be pulling on a string this time around. If we think of it a starter
cord for a lawnmower, the first several tugs may result in nothing, but
one additional pull has it going full speed. Maybe one of the upcoming
tightenings by the Fed will be that final pull. The risk/reward of
owning the long-end of the market is not favorable at this time. It is
possible that a sustained push higher in rates has already begun. At
the time of this writing the 10-year swap rate has already risen 31 bps
to 4.63% from its intraday low of nine days ago. Shortening duration
or purchasing put options on treasuries or payer's swaptions makes
sense. The cost of options is very reasonable at this time as implied
volatilities are near historical lows in reaction to the range-bound
nature of the market over the last few months. For those who do not
wish to incur the outlay associated with the outright purchase of
options, a collar strategy can be employed where calls/receiver options
are sold to offset the put/payer purchase. One should take advantage
of any short-term rallies to lighten up long positions or make the
suggested option trades.

Ron Yair
TRY Enterprises,

Old February 22nd 05, 09:18 PM
external usenet poster
Posts: n/a

I hope you're right........I'm long RRPIX

Old February 22nd 05, 10:01 PM
external usenet poster
Posts: n/a

it's not the fed's problem, it's YOUR problems. the fed makes money
by creating computer entries and charging interest on those entries.
they have their cake and eat it too.

Since time immemorial, the powerful have used religion to distract
the oppressed, to encourage them to focus on the next world so that
they will acquiesce to the injustices of this world. If you would
have your slaves remain docile, teach them hymns.