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What the Fed Really Said
by John Mauldin
July 1, 2006
Introduction
What the Fed Really Said
End of the Quarter Games
Blame it on the Japanese
Birthdays, La Jolla, and the Emperor's New Clothes |
Introduction
Thursday saw a powerful response by the markets in stocks, bonds, commodities,
and currencies to the communiqué from the Fed after its recent two-day meetings.
Clearly, some were interpreting the communiqué to mean that the Fed had finally
come to an end of its interest-rate-hiking ways. The immediate spin was quite
"dovish" in terms of future rate hikes and concern about inflation.
That has become a pattern in the last year. The Fed releases its minutes, the
immediate spin is that we are ready for a "pause," and the market rallies. Then
we start to listen to the speeches from Bernanke and various Fed governors and
are shocked - shocked, I tell you - that nothing has really changed and they
intend to keep on raising rates in a measured manner.
But is yesterday something different? Can we see a glimmer of hope that the Fed
is ready to pause? Is that the way to interpret the mere three paragraphs of
content? As a surprise to no one, I take a contrarian view, just as I did with
the May release. So, this week we parse the Fed release, take a look at the
yield curve, and glance over our shoulder at Japan. Maybe it will give us a clue
as to whether this week was a sucker's rally or the beginning of a bull run.
But first, I want to quickly highlight a new book which I would heartily commend
to you. Vernor Vinge has written a new book called Rainbow's End. Vinge is a
math and computer science professor from the University of California at San
Diego. He is one of the real experts on how technology will change and impact
society over the coming years. He is also a many-time award-winning science
fiction writer.
Rainbow's End is about the world of 2025, just 20 years from now. Vernor very
cleverly uses the device of a man waking from the long dark night of Alzheimer's
and finding himself completely at a loss as how to function in the new
technological order. Thus, a former English professor has to go back to middle
school to begin learning all over again. We see the wonder as he confronts new
technology that of course the kids take for granted but is all new to him.
As a science fiction read it is fun, and all hard sci-fi fans will want to get a
copy. But I suggest this is a book that should be read by investors. Think about
the technology that Vernor says will be here in 20 years. Which companies will
provide it? How will business be structured? What will the world be like when we
live in a wireless communications blanket with wearable computers of enormous
power, seeing virtual worlds on our contact lenses? How will your favorite
businesses compete? How will your business compete?
As many of you know, I am writing a book on how the next 20 years will unfold.
From my research, much of the technology which sounds so gee whiz in Rainbow's
End is already in the labs today. Some of it I think will take longer than 20
years, but some of it will be here in 5-10 years. But who really knows? With
change accelerating at an ever faster pace, much of the world he predicts may
seem old hat by 2025.
You can get your copy at
www.amazon.com. And now to the Fed statement.
What the Fed Really Said
There are typically five paragraphs in each statement. The first and last rarely
change, except to announce the interest-rate change. The short middle three
paragraphs provide the real substance. Let's take a look at the actual three
paragraphs. The changes from the May statement are in bold.
"Recent indicators suggest that economic growth is moderating from its quite
strong pace earlier this year, partly reflecting a gradual cooling of the
housing market and the lagged effects of increases in interest rates and energy
prices.
"Readings on core inflation have been elevated in recent months. Ongoing
productivity gains have held down the rise in unit labor costs, and inflation
expectations remain contained.
However, the high levels of resource utilization
and of the prices of energy and other commodities have the potential to sustain
inflation pressures.
"Although the moderation in the growth of aggregate demand should help to limit
inflation pressures over time, the Committee judges that some inflation risks
remain. The extent and timing of any
additional
firming
that may be needed to
address these risks will depend on the evolution of
the outlook for both
inflation and economic growth, as implied by incoming information. In any event,
the Committee will respond to changes in economic prospects as needed to support
the attainment of its objectives."
In January the Fed removed the word "measured" from the statement and everyone
interpreted that as dovish. We have since had four rate increases. In March, the
initial response was that a pause was imminent, as again the markets read what
they wanted to read into the statement. Last May, we again saw veteran Fed
watchers seeing a statement which led them to think the Fed would pause.
(For clarification, "dovish" means that one believes inflation is not going to
be a problem and therefore rates will not have to rise, and hawkish describes
the view that inflation is a potential problem and rates will need to rise.)
At the beginning of the rate-increase cycle, I said that the clear historical
pattern for the Fed is to raise rates higher and longer than anyone then thinks.
And it looks like this time is no exception.
Where does the dovish interpretation come from? The first sentence of the second
paragraph, where they acknowledge that economic growth is moderating. After
that, the statement reads rather hawkish to me.
The inclusion of the new sentence is key for me:
"However, the high levels of
resource utilization and of the prices of energy and other commodities have the
potential to sustain inflation pressures."
Let's emphasize the word "sustain." They are clearly acknowledging what we have
heard in speech after speech from Fed governors: inflation is now at an
uncomfortable level. "Elevated" is the term they use in the statement. And yes,
over time a slowing economy may indeed moderate those inflation pressures, as
they point out, but over time is probably not going to happen in the next 15
days.
And 15 days is when we will see the next inflation figures for June. Has anybody
noticed prices going down this month? Moderating? I don't see many hands going
up. It is likely that we will get another "elevated" inflation number that will
make the central banking gene in the voting members of the Fed governor create a
lot of late night stomach acid.
We will get one other number before the August 8 Fed meeting, and that is the
GDP number for the second quarter. The first-quarter number revision came out
today, and it was revised up to 5.6%. That is rip roaring, almost Asian
tiger-like growth. It is highly likely that GDP will come in stronger than 3%
for the second quarter, giving the Fed clear space to raise rates one again in
August.
Now, one can read the statement to make a case for a pause in September. There
will be two more inflation numbers before the September meeting. If the economy
is slowing down and inflation is coming down, both of which are possible, then
the Fed may indeed pause. But let's think about that.
A slowing economy is not going to be good for profits, and thus not good for the
stock market. But if the economy continues to rip and roar along with inflation
at an elevated level, then the Fed is going to continue to raise rates. There
are now some maverick calls that the Fed rate will be at 6% by the end of the
year. If you are bullish on the economy, then that is a perfectly rational
expectation.
But if rates continue to increase, then that is ultimately not going to be good
for mortgage rates and the housing market. That will also impact consumer
spending. That outcome is not good for the stock market either.
End of the Quarter Games
The market was already up 120 points when the Fed made its announcement and then
roared ahead almost another 100 points. So it was not all Bernanke. In fact, I
tend to think it was more likely end of the quarter gamesmanship, with funds
working to move their favorite stocks up, moving into stocks that will look good
in their portfolios and dumping the dogs. If XYZ stock is up 10% for the
quarter, you want some of it in your portfolio to show investors you were on top
of it. Of course, you don't have to say you got to the game late.
End of the quarter rallies are common. Any old excuse will do. My bet is that
whatever the Fed did would have produced a rally, short of stating that they had
decided a recession was in order.
But nothing fundamentally changed with the Fed rate increase. Thirty-year
mortgages are now around 6.6%, which is a good 150 basis points higher than a
few years ago. ARM rates are approaching 7% on an annual percentage basis, which
is far higher than the 2% available a few years ago. As these rates re-reset,
mortgage payments are going to go up considerably. Some new homeowners who
loaded up on ARMs two years ago are simply not going to be able to handle an
extra $2-4-600 a month increase without severely changing the rest of their
spending habits.
I think it is highly likely the Fed will keep raising rates until we get either
a slowdown or a recession. The irony is that the quicker the slowdown comes into
view, the less severe it is likely to be. Why?
If the economy starts to weaken in the third quarter, with inflation coming back
down, the Fed will stop raising rates. Given where we are today, it is likely we
get a simple mid-cycle slowdown, just like we did in the mid-'80s and mid-'90s,
and then the growth cycle continues.
But if the economy stays strong and inflation pressures do not abate, the Fed
will raise rates higher and higher, which will ultimately put more pressure on
the housing market and consumer spending. The risk is they go a raise (or three)
too far and the economy falls rather swiftly into a real slowdown and/or a
recession.
So, later in the summer, we are likely to be in the perverse situation where
good news is bad for the markets and bad news is merely less bad.
Blame it on the Japanese
This afternoon I had a conversation with bond maven Jim Bianco. I called him to
ask a question that has been perplexing me. Why haven't 90-day rates moved up
with the Fed funds? Fed funds are at 5.25%. The 3-month T-bill is at 4.98%. The
rest of the yield curve is acting normal for an inverted yield curve, but the
current 3-month action is strange from a historical perspective. If you can get
5.24% for a 6-month bill, then you should take the 6-month over the 3-month.
As it turns out, there is no good reason for the anomaly, or at least not one
that he knows of. And if anyone should know, it would be Jim. He thinks the
likely explanation is that there is so much "flight to quality" that it is
simply depressing the 3-month yield, as people who are looking for safety are
not overly worried about yield. That makes some sense, but it is playing games
with the yield curve.
The 6-month is now at 5.24% and the 10-year is at 5.14%, which is clearly an
inversion. If you assume that the 3-month should be in line with Fed funds or
3-month LIBOR, that would mean a full yield-curve inversion across the curve. If
that situation maintains itself, it suggests that we might see a serious
slowdown or a recession in the late second quarter or in the third quarter of
2007 - if the normal "lag" between the yield curve staying inverted for 90 days
and a recession showing up later is the same as it has been in the past.
In my conversation with Bianco, we discussed the Japanese taking the liquidity
out of the market as a reason for the recent market correction. The Japanese
money supply went from over 300 trillion yen down to 100 trillion yen in less
than two months. But interestingly, the Japanese have increased their money
supply by 50% in the last few weeks, back to 153 trillion yen, resupplying the
world with a measure of liquidity. Evidently, either they or someone decided
they went too far, too fast. Ultimately, they will mop up the excess liquidity,
but hopefully at a more "measured" pace, giving the markets more time to adjust.
And as we close, this note from Gary Shilling is a good way to wrap things up.
"Central banks hyped the money supply early in the decade in reaction to stock
meltdowns, 9/11 and deflation fears. But that money largely spurred asset
speculation, not economic growth. Now they worry about asset inflation spreading
to goods and services price hikes. So they're all constricting credit in
lock-step fashion. In dollar terms, combined 9 central bank money supplies grew
at a 7.9% annual rate from January 2001 through April 2006. Reducing that to 5%,
in line with economic targets, would slash the combined money supply by 13%, the
equivalent of a 10.9% cut in total GDP."
There are any number of headwinds to the economy, as Shilling and others
(including your humble analyst) have noted. Among these:
1. High energy prices serve as a tax
2. Central banks everywhere tightening
3. A slowing housing market
Sooner or later, I think they will take their toll. The growth in consumer
spending in recent years has been driven by rising home prices and the ability
of US consumers to have access to cash-out financing. Higher mortgage rates are
going to limit the growth in home prices and the ability of consumers to borrow,
as well as drain more cash from disposable income. With wages barely rising in
line with inflation, and not keeping up with the inflation of daily living, I
think the potential for a consumer-led slowdown or recession is significant if
the Fed keeps raising rates beyond August, and maybe/probably even if they do
pause in September. That will not be good for the markets.
As my friend Matt Blackman noted recently, the trend is for the market to bottom
in the third year of the presidential cycle. That would all fit if there is a
recession and the inevitable recovery in 2007. I continue to suggest that
readers look at absolute-return types of investments and be very careful of
long-only stock market investments. The time will come when it will be safe to
get back in the water. But in my opinion, that is not today.
Birthdays, La Jolla, and the Emperor's New Clothes
It is time to hit the send button. I am off to Atlanta tomorrow to help my great
friend Chip Wood celebrate his 65th birthday. There will be lots of friends and
it should be fun.
And speaking of birthdays, my daughter Amanda is celebrating her 21st birthday
with her friends at my office, watching a ballgame, and I am across the office
finishing this letter. I need to go be with her. Her twin sister Abigail is in
Tulsa celebrating with friends and going to summer school. It is hard to believe
that it has been almost 21 years since we saw them come off an airplane from
Korea. They were so small as we first held them. At six months old, they were
still smaller than their older sisters at their births. (But then Melissa was 12
pounds.) They have grown into two beautiful ladies, albeit still small at 4'10".
But they have giant hearts and make their Dad very proud. And did I say
beautiful? At least twice? Life is good.
I will be in La Jolla July 11-12 with my friends and partners at Altegris
Investments, meeting with clients and prospective clients. There are still some
slots available if you would like to meet with me. If you are interested in
learning more about, or investing in, alternative investments, hedge funds, and
commodity funds, I suggest you go to
http://www.accreditedinvestor.ws/ and sign
up. You can learn how I work with my various partners like Altegris Investments
around the world to bring you our best ideas.
(In this regard, I am president and a registered representative of Millennium
Wave Securities, LLC, member NASD. Please read the risk disclosures about hedge
funds carefully.)
As I mentioned last week, my kids spent three hours on Saturday helping me get
new clothes. It was a great deal of fun. I had not realized how much I had lost
as I dropped two sizes in jeans and my suits and shirts also went down in size.
Funny, I look in the mirror and still think I have not lost any weight, but the
scales say 25 pounds and counting. But the new clothes do make me feel good.
And next week I will share some of the other great things they did for me. It
has been a very good week. And now it is time to go party with my 21 year old
daughter.
Your having more fun than the law allows analyst,
John Mauldin
John@FrontLineThoughts.com
www.frontlinethoughts.com/gateway.htm
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