Commentary - Market Too Bullish on the Fed?

The minutes of March 22 FOMC meeting apparently baffled many Fed watchers. Commenting on that release, John Beery, a Bloomberg columnist wrote, “there appears ultimately to be more confusion than communication.” Unlike Mr. Beery, market wasn’t puzzled. In fact, stocks and bonds indices across-the-board rallied following the 2:00pm release of the minutes. Market’s reaction confirmed a hunch market participants had since March 22 FOMC meeting. The statement following that meeting had suggested that the Fed was inclined to act “appropriately” i.e. aggressively to contain insipient inflation. Economic data subsequent to the meeting, especially weak February factory orders and disappointing March non-farm payroll suggested an economy that was not rip-roaring but rather fragile. Market began to assume continuation of a “measured” policy and not start of an “appropriate” policy and became steadily bullish on the rate. June Fed Funds future contract, the best barometer of market’s view on Fed policy fell from 3.08% on March 23 to 3.05% on April 1 i.e. the probability of 50 basis points hike fell from 67% to 59% (see the Chart). Market’s hunch that the Fed will hike rates gradually was confirmed by the FOMC minutes (see my previous blog). This week’s weaker than anticipated retail sales provide more fodder to the gradualist school of thought.

Market has become more confident about the Fed’s gradualist policy since March 22 FOMC meeting. Not only has the short-term expectation, as per Fed Funds future, fallen, but the entire term structure of the interests has gone down as well (see the chart). The December 2005 Fed Funds futures contract anticipates 4.00% rate by the year-end, and the Eurodollar futures contracts suggest 4.40% rate in 2006, 4.57% in 2007, 4.79% in 2008 and 4.97% in 2009. This is quite a bullish view. Consider this. The economy is expected to grow above potential over the next two years (as per the Fed’s latest minutes), and if inflation stays at current level i.e. 3.0%, Taylor rule suggest that the Fed Funds should be at least 5.00% by next year.

While the market is very bullish on rates, there are even greater bulls out there. Bill Gross, the big honcho at Pimco, the world largest bond funds is one of them. He thinks that the Fed Funds rate by the year-end will be around 3.25% - 3.50%. He is pretty downbeat about the economy and thinks that the economy has already reached a cyclical peak and is going downhill from here. It seems that bond guys usually have pretty depressing view of the economy, while stock jocks are generally optimistic; I guess it’s the nature of their respective businesses. Even over the long-term, Gross is bullish. He argues that rates will remain relatively low mainly because the Fed does not want to destabilize highly leveraged financed-based U.S. economy. He has put money where his mouth is. According to Bloomberg, “Pimco holds a greater percentage of Treasuries maturing in three to five years than benchmark indexes on the view investors are overestimating how much the Fed will raise rates.”

I am more bearish on bonds. Personally, I think that the likelihood of Fed Funds rate going to 5.0% is higher than remaining around 4.0%. My guess is that the Fed Funds will end the year nearer to 4.00% than 3.50%, and from 4.00% to 5.00% is quite straightforward.

• There are 8 FOMC meetings in 2006. There is also the Congressional election and the nomination for Greenspan’s successor.
  
• The U.S. economy is likely to grow at a healthy clip despite Mr. Gross’ misgivings. It is true that more recent data suggest the economy hitting a soft patch but I think it is too premature to say that economic downturn has commenced. The U.S. economy has momentum going for it, and it takes a big shock to turn that momentum around. The economy is growing at 4.0% rate, above 3.5% potential. It won’t be surprising when the economy glides towards that growth rate, albeit not smoothly. Incidentally, the Blue Chip consensus estimates suggest the same.
  
• Headline inflation rate is around 3.0% and core is running around 2.0%. Core inflation has been creeping up since the end of last year, thanks to inflation in housing and transportation. Housing inflation is incidentally not due to the usual suspect, the so-called “owner’s equivalent rent.” That component has been decelerating since the beginning of the year. The culprits were rents and hotels. It is highly unlikely that core inflation will turnaround next year if, as expected, employment grows briskly and unit labor cost starts to accelerate. I am not as optimistic as the Fed on the ability of the firms to keep a lid on pricing through higher productivity. In my view, productivity has reached its cyclical peak (see the chart). If productivity decelerates and unit labor cost increases, then inflation generally follows (see the chart).
  
  
• Next year’s congressional election should not have any meaningful impact on Fed’s monetary policy. I am fairly certain that some politicians, both on the left and the right will try to make interest rate policy an election issue but they are not likely to succeed.
  
  
• Next year will be Greenspan’s last year at the Fed. He has been at the helm since 1987, just before the October crash. He has solidified his status by successfully managing the monetary policy through the ’87 crash, 1990-91 recession, 1995 Mexican crisis, 1997 Asian crisis, 1998 Russian crisis and the LTCM scandal, and the 2001 recession. His best call has been his bullishness, contrary to the conventional wisdom at the time, about the productivity growth in the U.S. Larry Meyer, a Fed governor from 1996-2002, in his book “A Term at the Fed: An Insider's View” credits Greenspan for being way of ahead of his peers in understanding the structural changes in the U.S. economy. In order to solidify his legacy, Greenspan will probably raise the rate to a normalized level – which I think is around 5.00% i.e. 2.0% real rate and 3.0% inflation – so that the next Chairman won’t be able to blame G-span for lax monetary policy.
  

A 5.0% fed funds rate, and historical 150 basis points spread with 10-year treasury suggest treasury around 6.50% or higher. That is more than 200 basis points higher than today’s level. If this scenario plays out, then this will obviously have quite a negative impact on the equity market. Details to follow.