Saturday, May 26, 2007

Fed remains likely to stay on course at 5.25% for all of 2007 and probably into 2008

[Warning: I may suspend this weekly post in the near future, but I haven't decided for sure yet.]

For now, my overall assessment of Fed monetary policy remains:

My view is that the Fed will keep the Fed funds target rate paused at 5.25% for all of 2007, and probably into 2008.

There will not be a recession this year, nor even enough of a growth slump to trigger a Fed rate cut.

The Fed will not cut rates in response to the concern about subprime mortgages.

The Fed will not worry about the health of the economy since it is a lot healthier than the 1.3% Q1 "real" GDP growth rate "estimate" suggests.

I tentatively say "for now" because I remain half-convinced that the Fed may in fact feel the need to make another hike in June or August to 5.50%. To my way of thinking, it all depends on what happens with energy commodities. Prices of oil and gasoline futures are still quite elevated, albeit off their Summer peaks, and this constitutes an ongoing source of inflationary pressure that continues to propagate throughout the economy. If prices of energy commodities resume their decline, the Fed will be able to remain paused for all of 2007. But if energy commodities prices do not continue to fall, the Fed may have little choice but to hike to 5.50% in August or September. If we don't see crude oil consistently below $50 and retail unleaded gasoline consistently under $2.00 by June, expect a Fed hike to 5.50% at the August or September FOMC meeting. Based on economic fundamentals, we should see the prices of energy commodities come back down to Earth, but unfortunately there is simply so much free cash sloshing around seeking "some action" and a lot of speculators are simply unable to resist the urge to try to run commodities prices back up since "it worked before." My view is that there is a fairly good chance that prices of energy commodities will recede in the coming months, but it may be too soon to bet too heavily against the speculators. My finger is on the trigger, but for now I'll retain my belief that the Fed will remain paused for at least another year.

My current feeling is that the 1.3% Q1 GDP number has frightened so many people (and emboldened so many bears and cynics) that the Fed may simply wait until the Q2 GDP number "prints" in late July before seriously considering a rate hike in August.

This coming week we will get the preliminary revision to Q1 GDP. Some serious people believe that it could be revised down to the 0.7% range. I normally don't pay that much attention to the GDP report, but I will be looking to see what they do with the inflation price deflator which was 4.0% in the advance report. In any case, the range for revision of annualized real Q1 GDP growth is from about a low of 0.5% to a high of 2.75%. A revised GDP number towards the lower end of that range will get people worried about slow growth again and raise the belief in earlier Fed rate cuts, while a GDP number towards the higher end of that range will take pressure off the concerns over growth and lower the belief in Fed rate cuts. Either way, half the market will rally and the other half will sell off. The two halves being the pro-rate-cut camp which believes that only rate cuts can keep the "rally" going and the pro-growth camp which focuses on economic and business fundamentals and sees economic growth as a boost for corporate revenues and profits and that rising earnings lead to rising stock prices. The two camps are roughly balanced, so predicting market reaction is rather dicey, but I still lean in the direction of stock prices experiencing a slow, gradual rise punctuated with bouts of volatility. A GDP number below 1.0% would make it more likely that the Fed will stay paused in August and a GDP number above 2.0% will increase the odds of a hike in August. The GDP report comes out at 8:30 a.m. this Thursday, May 31, 2007.

I am not suggesting that the Fed will "target" commodities prices such as crude oil and gasoline, but that the Fed will be noticing the degree to which elevated commodities prices are influencing the rest of the economy and pushing up even core prices over time. The price of crude oil remains up at $65.20 (up from $64.94 a week ago), which has to concern the Fed. The Fed is usally quite tolerant of short-term energy and food price spikes because they tend to quickly recede, but oil and gasoline and other energy prices have remained persistently high for a prolonged period of time, which results in upwards pressure on core, non-energy prices. Wholesale gasoline remains well above $2, and at $2.4037 last week (down slightly from $2.4077 a week ago) indicates an equilibrium retail level of $3.00 to $3.05, which is too far above $2 to give the Fed any comfort that inflationary pressures are "subdued."

My latest thinking is that $60 may be the magic number for crude oil for the Fed in June even though $50 is what they would really like to see. If crude is $60 or higher in June, the Fed will have a higher probability of a hike to 5.50% in August or September. If crude is below $50, the probability of a hike is very low. If crude is at $55, it will be a 50/50 coin flip. At $58, the Fed would seriously consider a hike. At $53, the Fed would likely hike only if there were some other significant factors, such as a strong resurgence in housing demand.

The point here is not $58 crude oil per se, but the fact that $58 crude oil means that either real demand is overly strong, or there is too much monetary liquidity in the financial system that inspires speculators to throw too much money around because it is relatively too cheap and the Fed will feel some pressure to "mop up" such excess liquidity to the extent that it causes higher core inflation in the real economy.

Although the moderation of the housing boom will indeed hold back the economy over the next couple of quarters, the Fed seems to agree with me that this is to be expected and not an indicator of a coming recession. A lot of people have been desperately funneling money into bond funds in response to an expectation of well below-par economic growth, and this has depressed Treasury yields and caused an inverted yield curve, but this is ultimately indicating only below-par growth (e.g., 2% to 2.75% rather than 3+%) for the coming six months. Yes, there is a lot of anxiety, but anxiety itself is not a reliable indicator of a particular outcome.

Please note that current Fed policy at 5.25%, or even a hike to 5.50%, is not restrictive, but within the neutral range which is neither accommodative nor restrictive. All "normal" economic activities can be easily financed with Fed policy at this level. This does eliminate a lot of excessive speculative behavior, but won't crimp the average business or consumer. The odds of such a hike causing a recession are negligible.

As of Friday, Fed funds futures contracts indicate the following probabilities for changes in the Fed funds target rate at upcoming FOMC meetings:

  • June 27/28, 2007: 2% chance of a cut -- effectively zero chance
  • August 7, 2007: 8% chance of a cut -- effectively zero chance
  • September 18, 2007: 16% chance of a cut -- people are confused and uncertain, but a cut is still unlikely 
  • October 30/31, 2007: 28% chance of a cut -- people are confused and uncertain, but a cut is still unlikely
  • December 11, 2007: 48% chance of a cut -- people are really confused and uncertain, but a cut is still unlikely
  • January 2008: 70% chance of a cut -- a cut is likely
  • March 2008: 94% chance of a cut
  • May 2008: 100% chance of a cut and 6% chance of a second cut

The June FOMC meeting is now within the 45-day window of reliability for fed funds futures to predict Fed action, so it is a high-probability indicator of the degree of certainty that the Fed will not change the fed funds target rate at the June FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the August or September FOMC meetings. A lot can and will transpire during the run-up to the June and August meetings to whipsaw the odds for a rate change at those meetings. My belief is that the odds of a cut will completely evaporate and in fact turn into odds for a hike in August.

I personally don't concur with these odds after August, but that is how a lot of people are actually "betting." I would simply note that such betting can change on a moment's notice as economic and financial data, not to mention commentary and sentiment, unfolds and evolves -- which is precisely what we saw this past week. Like it or not, the economy proceeds more through Darwinian evolution than "intelligent design." Emergent phenomena and evolution are the norms for the economy. The Fed (and Wall Street) can influence the evolution, of the economy, but not control it as if it were a clockwork machine. Predicting the precise or even general impact of any Fed action or inaction is quite literally a fool's errand. Further, the "betting" on any last Fed move is usually more of an insurance hedge than an outright bet, more of a "just in case I'm wrong" kind of "bet." Finally, studies have shown that Fed funds futures are not a very reliable indicator more than 45 days into the future.

What the Fed funds futures market tells us clearly is that the Fed is most likely to leave rates unchanged at least through December. The market is predicting a cut at the January FOMC meeting, but that is too far in the future for the market to give a reliable forecast.

My feeling is that since the housing retrenchment and so-called subprime "crisis" didn't cause a Fed cut at the January (or March) FOMC meeting, it is unlikely that housing or the so-called subprime "crisis" will be enough of a problem to cause a Fed cut for the rest of the year either.

As of the May 4, 2007 edition of the UBS As We See It - Market Viewpoint report, UBS Wealth Management Research continues to forecast a Fed funds rate of 4.00% by the end of 2007. That would be five quarter-point cuts. They are also forecasting a Fed funds rate of 3.75% by the end of 2008. They continue to forecast 2% GDP growth for 2007. Obviously I do not concur, although I welcome their alternative perspective. At least they are now admitting that "A first rate cut in June seems less likely now" and that "The tentative signs of a growth revival put into question our aggressive Fed call, both in terms of timing and scope." They conclude that "For now, we are waiting for more growth data before reassessing our call." It sounds to me that their commitment to their "call" is rapidly crumbling and that they themselves are on the verge of admitting that they are clueless.

Why would the UBS outlook be so far off from my own view or even from the pessimistic market view? The wide divergence of these views doesn't make sense, right? Well, that's true if one were considering only economic fundamentals, but we do need to take into account that UBS has a customer base that they want to preserve and that the "research" document I referenced is really marketing literature, most likely designed to make the existing UBS customer base feel that UBS is "in touch" with their customers and their "needs." That is par for the course with the big financial firms. Step 1 is to understand the hopes and fears and anxieties of your customers and step 2 is to directly tap into those hopes and fears and anxieties. Right now, a lot of people hear so many desperate and gloomy stories in the media and internalize that desperation and gloom, and the result is that firms like UBS have no choice but to send out a message of "we understand and share your fears and anxieties." Better to be wrong and keep your customer base than be right and lose your customers. The bottom line is that individual investors cannot look to the research and economic outlooks peddled by Wall Street for a balanced accurate view of how the conomy and businesses will likely unfold in the coming months or year or over any period of time.

The bottom line here is that the Fed won't move through December, and any speculation about Fed moves further down the road are simply wild guesses based on contrived stories about a hypothetical future economy that happens to have a mind of its own.

Why are so many smart people so confused about the future? It is simply the fact that the conservative thing for them to do is to assume that economic events such as housing booms always play out in the same pattern every single time. For a bureaucrat, that is always the safe approach. Alas, every economic episode has its own idiosyncratic pattern and the real issue is how to forecast the interactions between the many sectors and regions of the economy, and that is a really hard problem that is absolutely not amenable to the cookie-cutter application of historical patterns.

The current "herd mentality" on Wall Street is basically sending so many speculators and even investors off on a truly wild goose chase, after which Wall Street will quietly acknowledge its error ("the data changed in an unexpected manner") and then chase those same speculators and investors back in the opposite direction, making sure to collect transaction fees and spreads on both legs of the roundtrip "chase." Expect to see a reversal of the trend of the past week within a month.

Note that the Weekly Leading Index of the Economic Cycle Research Institute is telling us that the economy will be holding together reasonably well for at least the next few months.

-- Jack Krupansky

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