Saturday, July 14, 2007

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

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

The market continues to be very non-commital as to how confident people are that the Fed will or won't cut rates in 2008. The market almost flip-flopped again this past week, but still narrowing forecasts no rate cut out to June 2008. There will probably be enough wiggle room concerning the economic outlook for the next several quarters to keep the market completely on edge when looking out nine months to a year. The good news is that there is a reasonably strong consensus that the economy will hang in there reasonably well for at least the next two quarters. Until we get a firm reading on Q2 and even Q3, it will be difficult to convince some people that the economy is actually beginning to pick up again.

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 well 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 MUCH healthier than the 0.7% Q1 "real" GDP growth rate "estimate" suggests.

I would suggest that there is a 1 in 3 chance that the Fed will hike rates by a quarter-point before the end of the year.

I tentatively say "for now" because I remain partially convinced that the Fed may in fact feel the need to make another hike before the end of the year 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 modestly off their Summer 2007 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% before the end of the year. 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 0.7% Q1 GDP number has frightened so many people (and emboldened so many bears and cynics) that the Fed will likely simply wait until the Q2 and Q3 GDP numbers "print" before seriously considering a rate hike to make sure that the strength we were seeing in Q2 is really sustainable.

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 $73.93 (up moderately from $72.81 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 at least modest upwards pressure on core, non-energy prices. Wholesale gasoline remains well above $2, and at $2.2248 last week (down very sharply from $2.3096 a week ago) indicates an equilibrium retail level of $2.82 to $2.87, which is too far above $2 to give the Fed any comfort that inflationary pressures are "subdued."

The point here is not the price of crude oil and gasoline per se, but the fact that elevated prices 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 partially inverted yield curve (on some days), but this is ultimately indicating only below-par growth (e.g., 2.25% to 3.25% rather than 3.00% to 4.00%) 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 (approximately 4.25% to 5.75%.) 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:

  • August 7, 2007: 4% chance of a cut -- slam dunk for no change
  • September 18, 2007: 8% chance of a cut
  • October 30/31, 2007: 12% chance of a cut
  • December 11, 2007: 12% chance of a cut
  • January 2008: 20% chance of a cut
  • March 2008: 32% chance of a cut
  • May 2008: 42% chance of a cut
  • June 2008: 48% chance of a cut

The August FOMC meeting is well within the 45-day window of reliability for fed funds futures to predict Fed action, so it is a virtual certainty that the Fed will not change the fed funds target rate at the August FOMC meeting. It is too soon for fed funds futures to reliably predict rates for the September or October FOMC meetings. A lot can and will transpire during the run-up to the August, September, and October meetings to whipsaw the odds for a rate change at those meetings, although in recent months the rate outlook in the near months has been quite stable. My belief is that we will begin to see rising odds for a hike later in the year.

I would 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. 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 will most likely leave rates unchanged through Q2 of 2008.

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.

In the July 13, 2007 edition of the UBS As We See It - Market Viewpoint report, UBS Wealth Management Research suddenly dropped all commentary about the Fed but simply kept their recent forecast for a Fed funds rate of 5.00% by the end of 2007and a total of three quarter-point cuts (versus a forecast of 4.50% and six cuts just a month ago.) Two weeks ago they told us that "The healthier US economy prompts us to delay the first Fed cut to December from September 2007 and to expect less total easing of 75 basis points instead of 150." They now forecast a Fed funds rate of 4.50% by the end of 2008 compared to their forecast of 3.75% just a month ago. They continue to forecast 2% GDP growth for 2007. Obviously I do not concur, although I welcome their alternative perspective. 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.

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.

The Weekly Leading Index of the Economic Cycle Research Institute is telling us, according to Lakshman Achuthan, managing director at ECRI, that "With WLI growth at its highest reading in over three years, U.S. economic growth is bound to pick up in the months ahead."

I'll continue with this post series as long as I continue to see evolution in how people view the outlook for Fed rate action.

-- Jack Krupansky

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