Inflation vs. Growth: Bernankes Mission Impossible?
Aside from having to prove his much headlined inflation-targeting priorities, Fed Chairman Bernanke must show real juggling abilities, balancing the upside risks of inflation with the downside risks to slowing growth resulting from an overstretched consumer, falling equities and cooling home prices.
The chart below shows the historical parallels between the yield curve and the stock market. The red graph above represents the 10-2 yield spread--a measure of the steepness of the yield curve. The first two green circles show the two periods of yield curve inversions -- summer 1998 and most of 2000. In each of those cases, the stock market -- as indicated by the S&P500 in the bottom chart -- reached a peak 1-2 months after the beginning of the inversion, followed by sharp sell-off.
In 1998, the S&P500 peaked about 1.5 months after the yield curve began inverting in July of that year, then fell 18% in the following 6 weeks.
In 2000, the S&P500 peaked about 2 months after the yield curve began inverting in February of that year, then went on to shed 50% in the ensuing 2.5 years.
In 2006, the S&P500 peaked 3 months after the yield curve began inverting in late January, and is now 5.0% down from its May 5 peak.
Indeed, the market and macroeconomic conditions in 1998 and 2000 were not comparable; with drying capital market liquidity and increased volatility stemming largely from emerging market sell-offs in 1998; and excessively overvalued stock prices founded on negative present values.
But both periods involved a notable rise in the short-term rates above longer term rates (1998 due to drying up of liquidity and 2000 due to 150 bps in fed funds rate tightening in May 1999-2000) to the extent that the overnight rate (not only the 2-year yield) exceeded 10-year yields, helping to trigger a market downturn.
Shifting its focus from ending the excessive stock valuations of 2000 to containing the surge in house prices of 2005, the Fed seems to have approached its goal. With annual median prices of existing home sales down more than 8% from their winter 2005 peak, weekly mortgage applications near their 3-year lows and 1-year adjustable rates at 5-year highs, the cooling process isn't far from freezing in the event that oil prices take a new lease on their ascendant life.
On an even more sobering note, the Federal Reserve may have to continue raising interest rates even as the 5.00% fed funds rates creeps around the 10-year yield of 5.02-04%--usually a market signal for halt in the tightening campaign.
But we expect persistent inflationary expectations (Thursday's core PCE price index seen at 2.1%) to push up 10-year yields towards the 5.20-5.25% territory, requiring the Fed to raise its overnight rate to 5.25% at its June meeting. Though this may temper bond vigilantes, expect the already shaky stock market to shed further losses, handing the new Fed Chairman the classic of all central bank dilemmas; rising inflation vs. spreading market malaise -- and eventually slowing economic growth. Bernanke would have to resort to his previously unused money-sucking helicopters this summer, making the usual mid-election market doldrums louder than usual.
Though such obligatory easing may help lend the greenback some stability, the much anticipated rate hikes from the BoJ, ECB and BoE will be sufficient in offsetting the greenback's stability. Despite the talk of globalization and the role of China, we think the only durable force responsible for containing inflationary expectations is an actual slowdown in US aggregate demand.
A 25-bp rate hike in June will be much needed for bonds but not tolerated by equities. An expected 8-10% decline in the S&P500 in Q3, coupled with a more protracted pullback in home prices and new home sales, would necessitate the Fed to shift towards an easing bias (not rate cut) in late Q4. An accelerated decline in the dollar in Q4 should prevent the Fed from delivering the necessary easing.
We adjust our year-end target for EURUSD and USDJPY to 1.3200 and 107.
Yen boosted by S&P upgrade
Yen made the biggest surge of the day --from 111.70 to 111.00 after S&P upgraded Japan's long-term sovereign rating to positive from stable due to improved economic prospects, fading deflationary conditions and the turnaround in the banking sector. S&P expects the govt deficit down below 6% Of GDP in fiscal 2006 with the long-term and short-term ratings both affirmed at AA-/A-1+.
Now that BoJ's Fukui affirmed the central bank will adopt a gradual course towards raising interest rates, this raises expectations that a rate hike would most likely be delayed to the July 14 meeting. We think that one key obstacle to the Bank of Japan's ending of ZIRP in July would be a decision by the Fed to NOT raise rates at its June 28-29 meeting at which case the yen could see excessive appreciation vs. the dollar. But since a Fed rate hike in June would raise speculation of a BoJ rate hike in July, this could help build further support for the Japanese currency.
Selling interest has risen at the 111.40-45 territory, with preliminary target at 111.00, just above the 110.93 -- 50% retracement of the 108.97-112.92 rise. Deteriorating momentum seen extending the pair towards 110.75.
EURUSD seen capped at 1.29, until Wednesday
The dearth of US-EU data will come to an end tomorrow at the release of the US new home sales and Germany's IFO. The latter is expected to post a modest drop from the unexpectedly fresh 15 ½ year highs in the April figure, while the US new home sales on the same day should be essential in determining the trend for the rest of the week. The US GDP report will draw focus on the PCE, but most of all will be Friday's release of the core PCE price index for the Fed's preferred inflation measure. We do not expect much FX substance from neither Bernanke nor Snow in today's Senate appearance on financial literacy, but the Q&A should always prove worthy of interest.
We see initial support at 1.2835 -- the 59% retracement of the 1.29715-1.2692 move, backed by 1.2800. Upside seen short-lived at 1.2885, with increased pressure at 1.2920.