World Glut 2006*
The following is an excerpt from our 12 June Latest Letter.
...meanwhile the brazilian girls are dancing in the Berlin streets - Brazil plays Croatia today and its in the 90s (33 °c) today - must be a cooker down on the pitch - playing in the refurbished Olympic Stadium. I just went to buy Barron's newspaper and the turkish kiosk seller is wearing a Brazil T-shirt ... he said he likes the dancing girls...
The markets are dancing too - but they've lost their pants while doing the samba! It doesn't matter where one looks - a sea of red on the monitor - been like that for weeks now. At first we heard "Me worry? - it's a needed correction" ... now we're hearing "Maybe it's more - where's the exit?" Somebody told me that markets, on average, drop seven times (7x) faster than it takes to rise. This year we're close : from Dec 31 to now, markets have risen and given back near everything in 3 weeks, since 18 May.
We don't want to kick a beaten down dog any longer and complain as many have about the recent market corrections everywhere - emerging, precious metals, major indices worldwide, etc. Often pleasure and pain are very close to one another - gold bugs can attest to that right now (gold is down $40 today to $567) just as those invested in the big markets can. Fear works its way quickly around in a globalized world - it ain't a one-way street out there. A non-investing friend from Germany once asked me why everybody follows the US markets when they are not in the US - damn good question: LINKAGE. Other world markets have become more and more zombies of the US markets - all these charts look EXACTLY the same. Oversupply of USDollars and the increased usage of technology / telecommuncations / computer-aided trading enables more linkage and the usage of rule-based computing. Have you ever looked at the closing charts of major world markets (as shown above) - it's like looking at twins but instead of 2 its 7 or 8 (septuplets) ...that's why - US sets the die and others cast themselves to them.
What has been the prevailing die? Easy liquidity. The entire western world along with Japan have been the leading "producers" of easy money the last 4-5 years after the dot.com blowout. In the simplest of terms, monetary investment will expand to fill the amount of liquidity alloted to it. That is to say, the recent run up in many sectors and markets have been feeding on the "easy" money which has been injected into world economies over the last years - as we have always talked about, feed-through times, or lag times, can take anywhere from 6 to 18 months to trickle through the financial system. Housing and asset prices, stock prices, energy prices, food prices, etc. have all been on a good run over this time period. We all have seen it. Now the central banks are saying they see too much "inflation" in the pipeline (which they created) and directly infers that we need to "hunker down" and fight inflation - the oddest of things is this - the banks may now have brought about a situation where the battle they say they are fighting against may now only become worse than they intended, but later.
By raising both the rhetoric and rates, the Fed and other central banks (CB) around the world have been increasing the market tension and the result has been a world-wide selloff in the markets, gold included has gotten sucked up in a psychological battle even as the stupidity of media has been explaining for years that gold is a HEDGE in an inflationary environment - sorry, but gold has been rising for 6 years and the talk of inflation is a "phenomena" of the last 6 months! Obviously gold has been rising on other factors than just inflation. But getting back to the core, if the Fed and ECB are now worried about inflation then they surely must be playing a high-stakes game of poker: IF the world economy on their CB "we need to be vigilant on inflation" mantra should fall into a protracted stagflation, or dread, deflationary cycle, then can this be good for their respective economies? Clearly no. Hence they ought not be wishing for such and surely should not be beating the raise-rate drums too loud. So just as asset prices (a consumption driver) in the US, and possibly elsewhere in Europe are falling, the CBs are raising rates. The truth of where rates should be, lies below the rhetoric and above historical lows.
Where's the irony? The irony is that Bernanke at the Fed is some economic history buff who studied(s) the history of DEFLATION. Could Bernanke be ushering in a deflationary type recession where his "man-handling" of the rates spooks the world markets MORE than they already are these last weeks? And do we think that the near-perfect raising of interest rates by CBs throughout the world is some sort of coincidence? Again, if Bernanke and Trichet get too damn enthralled with "fighting inflation" then we may well see a protracted economic downturn.
The bottomline is this: The western nations may be facing a recessionary or slowing down but if the economic data starts to turn sour then our conjecture is that Bernanke will need to again raise liquidity (lower rates) because that is in fact one of their core mandates - maintain price stability and growth via managing inflation expectations. In fact, the Fed's core targeted inflation is always around 2%. Our estimation of this from January this year was that by Q4/2006 the FFR (baseline Fed interest rate) would be 5.25 or 5.5% (2 more 25bp hikes). We are sticking by this figure. In fact, we see an easing off of rates by December as this current ferocious market pullback has probably caused sufficent fear in the FOMC committee that the message has been taken and price stability is falling back into line. The lag time for this stablization should last into Q2 of 2007. A final note: We have read economic reports that the targeted inflation rate of 1 to 2% has been missed to the upside and hence all wheels are in motion at the Fed to "bring that sucker" down into "normal channels". The problem with a rule and data based monetary policy is that a) rules don't always work (give the desired results) given the parameters at hand, and b) macro data is always backward looking not forward looking. Here's something from NBER to ponder:
Recent empirical research shows that a reasonable characterization of federal-funds-rate targeting behavior is that the change in the target rate depends on the maturity structure of interest rates and exhibits little dependence on lagged target rates. See, for example, Cochrane and Piazzesi (2002). The result echoes the policy rule used by McCallum (1994) to rationalize the empirical failure of the `expectations hypothesis' applied to the term- structure of interest rates. That is, rather than forward rates acting as unbiased predictors of future short rates, the historical evidence suggests that the correlation between forward rates and future short rates is surprisingly low. McCallum showed that a desire by the monetary authority to adjust short rates in response to exogenous shocks to the term premiums imbedded in long rates (i.e. "yield-curve smoothing"), along with a desire for smoothing interest rates across time, can generate term structures that account for the puzzling regression results of Fama and Bliss (1987). McCallum also clearly pointed out that this reduced-form approach to the policy rule, although naturally forward looking, needed to be studied further in the context of other response functions such as the now standard Taylor (1993) rule. We explore both the robustness of McCallum's result to endogenous models of the term premium and also its connections to the Taylor Rule. We model the term premium endogenously using two different models in the class of affine term structure models studied in Duffie and Kan (1996): a stochastic volatility model and a stochastic price-of- risk model. We then solve for equilibrium term structures in environments in which interest rate targeting follows a rule such as the one suggested by McCallum (i.e., the "McCallum Rule"). We demonstrate that McCallum's original result generalizes in a natural way to this broader class of models. To understand the connection to the Taylor Rule, we then consider two structural macroeconomic models which have reduced forms that correspond to the two affine models and provide a macroeconomic interpretation of abstract state variables (as in Ang and Piazzesi (2003)). Moreover, such structural models allow us to interpret the parameters of the term-structure model in terms of the parameters governing preferences, technologies, and policy rules. We show how a monetary policy rule will manifest itself in the equilibrium asset-pricing kernel and, hence, the equilibrium term structure. We then show how this policy can be implemented with an interest-rate targeting rule. This provides us with a set of restrictions under which the Taylor and McCallum Rules are equivalent in the sense if implementing the same monetary policy. We conclude with some numerical examples that explore the quantitative link between these two models of monetary policy.
The upshot being: based on current targeted inflation rates and where "inflation" is now, Bernanke could theoretically, using macroeconomic rules of Taylor/McCallum entailing a 150bp move, be heading for 6.5%. We currently think this is too aggressive. The markets have corrected heavily (and psychologically) and market-makers have seemingly baked the next rate hike into the upcoming June cake supporting USD holders. IF Bernanke and Co. are reading the tea-leaves "correctly" then we feel an easing or halting at the June meeting is in order such to digest the commodity and broad market pullbacks along with housing. Were this to happen we would see a strong rebound in the markets and more weakness in the US Dollar. Right now, the USD is being supported in a "flight" to cash - but maybe it would be more prudent, if holding cash, to do it in something other than USDs. Cash is still cash and risk is risk.
Of course, being a Professor of Economics, and data-driven, we should not preclude a modicum of common sense on his part, for if he doesn't grasp the psychology aspect of markets, the US consumer, and the world along with him, may start to feel a bit more nervous than the recent market pullback has shown, and God forbid, a deflationary triggering. That would be irony, Ben.
*World Cup 2006 is a registered Trademark of FIFA
World Glut 2006 is a market reality.