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If Fed Funds Rate “Fails” To Fall
February 2007 (Paul McCulley - PIMCO)
What has been extraordinary since the Fed stopped [tightening] has been the markets’ willingness to quickly discount a reversal to easing, as shown in Chart 1, despite the Fed’s continued preaching of upside inflation risks and a bias towards further tightening, in the context of the ex-housing economy holding up well and a falling unemployment rate.
To be sure, markets, notably the bond market, always front run the Fed in discounting a reversal to easing after a prolonged tightening cycle. But, as Chart 2 displays, this cycle is unique in the willingness of the markets to ease financial conditions in anticipation of a reversal to Fed policy easing, without:
AntiSpin: Here's another theory: the reason for the apparent discounting of future Fed rate cuts by the bond market isn't Fed body language driven. Maybe the bond market doesn't much care what the Fed says or doesn't say it might or might not do. It may not even what the Fed finally does. What if the bond market is not front running the Fed as much as following indicators which the Fed itself is following, too?
What the bond market may be waiting for is not some confirmation of possible easing by the Fed but for a sign of impending change in the status quo of foreign central bank financing of U.S. trade and fiscal deficits. Actions by central banks of goods and energy producing and capital accumulating (GEPCA) countries have competing needs for economic growth, inflation control, and financial markets stability from the Fed. The Fed must carefully influence, via interest rates and money supply changes, the economy of the goods and energy consuming and capital expelling (GECCE) U.S.A. In a way, they have collectively become a kind of reverse IMF, supporting the USA the way the USA, by paying into the IMF, used to support emerging market economies–except without the declared emergency. But certainly everyone–bond traders and central bankers–knows that a sudden withdrawl of this support will create an emergency, so it does not happen.
A bond trader might be bold enough to bet that through a reduction in foreign demand for US treasury and agency debt, bonds might be allowed to fall and interest rates to rise. For the past several years, betting against the will of global central banks to help maintain a system in imbalance is a loser. So the bond market waits for a sign that global central bank cooperation may change. A measure of future global central bank cooperation may correlate well to McCulley's chart.The threshold to watch, then, is of change, real or perceived, in level of cooperation among global central banks to support an increasingly unstable quid pro quo within the framework of an antiquated international monetary system. But what is the measure and, more importantly, what are the leading indicators, the signs?
The most important determinants of central bank cooperation that are under the Fed's influence are inflation and economic growth policy. If the Fed appears willing to allow inflation to rise too far, bonds will sell off and interest rates will rise. If, on the other hand, the Fed appears willing to allow a declining housing market to drag the U.S. into economic recession and a self-reinforcing decline in demand, bonds may also sell off, as foreign investment follows the path of relative economic growth and demand for exports from GEPCA countries.
Given the way global gold, oil, and stock prices move on US politics and war news, perhaps the leading indicator of inflation, US economic growth, and financial market stability–and therefor of future bond prices–is the housing market, the Middle East wars, and U.S. presidential and congressional politics.
February 2007 (Paul McCulley - PIMCO)
What has been extraordinary since the Fed stopped [tightening] has been the markets’ willingness to quickly discount a reversal to easing, as shown in Chart 1, despite the Fed’s continued preaching of upside inflation risks and a bias towards further tightening, in the context of the ex-housing economy holding up well and a falling unemployment rate.
To be sure, markets, notably the bond market, always front run the Fed in discounting a reversal to easing after a prolonged tightening cycle. But, as Chart 2 displays, this cycle is unique in the willingness of the markets to ease financial conditions in anticipation of a reversal to Fed policy easing, without:
- In-the-face fundamental evidence pointing in that direction, notably a rising unemployment rate, and/or
- A gathering storm of financial instability and widening risk premiums.
AntiSpin: Here's another theory: the reason for the apparent discounting of future Fed rate cuts by the bond market isn't Fed body language driven. Maybe the bond market doesn't much care what the Fed says or doesn't say it might or might not do. It may not even what the Fed finally does. What if the bond market is not front running the Fed as much as following indicators which the Fed itself is following, too?
What the bond market may be waiting for is not some confirmation of possible easing by the Fed but for a sign of impending change in the status quo of foreign central bank financing of U.S. trade and fiscal deficits. Actions by central banks of goods and energy producing and capital accumulating (GEPCA) countries have competing needs for economic growth, inflation control, and financial markets stability from the Fed. The Fed must carefully influence, via interest rates and money supply changes, the economy of the goods and energy consuming and capital expelling (GECCE) U.S.A. In a way, they have collectively become a kind of reverse IMF, supporting the USA the way the USA, by paying into the IMF, used to support emerging market economies–except without the declared emergency. But certainly everyone–bond traders and central bankers–knows that a sudden withdrawl of this support will create an emergency, so it does not happen.
A bond trader might be bold enough to bet that through a reduction in foreign demand for US treasury and agency debt, bonds might be allowed to fall and interest rates to rise. For the past several years, betting against the will of global central banks to help maintain a system in imbalance is a loser. So the bond market waits for a sign that global central bank cooperation may change. A measure of future global central bank cooperation may correlate well to McCulley's chart.The threshold to watch, then, is of change, real or perceived, in level of cooperation among global central banks to support an increasingly unstable quid pro quo within the framework of an antiquated international monetary system. But what is the measure and, more importantly, what are the leading indicators, the signs?
The most important determinants of central bank cooperation that are under the Fed's influence are inflation and economic growth policy. If the Fed appears willing to allow inflation to rise too far, bonds will sell off and interest rates will rise. If, on the other hand, the Fed appears willing to allow a declining housing market to drag the U.S. into economic recession and a self-reinforcing decline in demand, bonds may also sell off, as foreign investment follows the path of relative economic growth and demand for exports from GEPCA countries.
Given the way global gold, oil, and stock prices move on US politics and war news, perhaps the leading indicator of inflation, US economic growth, and financial market stability–and therefor of future bond prices–is the housing market, the Middle East wars, and U.S. presidential and congressional politics.
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