The Most Unlikely Action

By: John Mauldin | Sat, Jul 19, 2003
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This week we look at what Greenspan really said and what he didn't say; the real reason why the bond market reacted so violently (not what the headlines would lead us to believe); what History tells us about the volatility of the bond markets and what we can expect in the future. It should make for a lively letter, as I wrap up the week early to catch a plane to Paris. Stay with me, as this letter is going to give you some real insight into the bond markets, a "secret" called the "6/50 Rule," which will help you as you ponder interest rates and your investment future. Let's jump right in.

What in the Wide, Wide World of Sports Did Greenspan Say?

Last week I compared this week's Greenspan testimony to the last card dealt in a Texas Hold'Em poker game. If Greenspan did not confirm to the bond market the substance (read bluff) of recent speeches by members of the Federal Reserve, bond traders would call the bluff and rates would jump back up. He didn't and they did.

There were two key phrases. The first was, "...the FOMC stands ready to maintain a highly accommodative stance of policy for as long as it takes to achieve a return to satisfactory economic performance." This sentence was actually in the prepared statement twice. As more than one report related, "This statement was designed to re-ignite the "carry trade" that helped lower 10-year Treasury bond yields by roughly 80 basis points following the Fed's May 6, 2003 meeting." (This direct quote was from noted economist Brian Wesbury.)

I agree. But then most reporters and analysts went on to note that the bond market vigilantes reacted to the upbeat economic predictions (more later), sensed inflation and a return to powerhouse growth and long term interest rates soared on that forecast.

Well, maybe, but I look for other more prosaic reasons for the bond market sell-off.

First, to be very clear, the Fed forecast is nothing short of spectacular. As an editorial in the London Financial Times told us, "The Fed chairman remains optimistic that the much-postponed US recovery is on the way. The central bank's forecasts for growth this year, at between 2.5 and 2.75 percent, is a bit lower than it was in February and below potential for the third straight year. But the Fed says growth should accelerate next year to somewhere between 3.75 and 4.75 percent."

Translation: "We were wrong about the growth rates before (and have been for several years), but this time we are absolutely, positively sure the second half recovery is finally here after three years."

That is real, after inflation growth they are projecting. Since Greenspan relegated deflation to the back bench in this testimony, presumably he thinks inflation will be up somewhat. That means nominal growth could easily be between 6%-7% OR MORE. Gentle reader, that is not just good growth. That is house a-fire growth. Even the always optimistic (and of late consistently wrong) main stream economist publication Blue Chip Economic Indicators, "only" projects 3.7%, which is more or less consistent with their predictions for recovery in the last few years. Some day, as the proverbial stopped clock, they will eventually be right. I do hope so. 3.7% sounds more fun than the current Muddle Through 1.5%.

Greenspan was not so upbeat in his actual testimony, however. Even the Wall Street Journal noted, quoting Greenspan, "there is as yet little evidence" higher stock prices and lower corporate borrowing costs has "improved the willingness of top executives to increase investment," despite some "tentative" signs.

Going on, "While consumer spending continued to hold up, employment and production data were "mixed," he said. Business hiring and investment was hampered by "a pervasive sense of caution," which he blamed on the "aftermath of corporate governance scandals." Mr. Greenspan didn't blame terrorism, Iraq or other "geopolitical" risks for the sluggish economy, as he did earlier this year, though he did cite the recent rise in oil prices and persistently high natural-gas prices as well as "flagging" demand overseas as downside risks." (Wall Street Journal, July 16, 2003)

The testimony was classic Greenspan: allude to "potential" recovery, positive "tendencies" but don't cite actual figures, while mentioning the problems as "risks." Indeed, as Art Cashin noted to me in a puzzled conversation we had the next day, while trying to parse the subtleties of the speech, this is the first time in his memory (which by his own account can be politely termed lengthy) that a Federal Reserve chairman extolled the virtues of consumers borrowing against the home equity values and being willing to take risk in the form of buying junk bonds as positive signs for the economy.

The pundits said the bond market bought the growth story and drove up rates in anticipation of a major economic recovery that Greenspan promises is just around the corner. I don't buy their spin.

The Most Unlikely Action

The real reason for the implosion of the bond market is in another Greenspan sentence: "...situations requiring special policy actions are most unlikely to arise....with the target funds rate at 1 percent, substantial further conventional easings could be implemented."

I heard "situations requiring special policy actions are most unlikely to arise...." and hit the mute button. That was all I needed to hear. The rest was window dressing, and could be read at leisure, if reading Greenspan speeches can be called leisure. The bond market would implode from that point on.

The simple fact is that the bond market had been listening to speeches from Federal Reserve members, including Greenspan, which clearly indicated they thought deflation was a problem, and that they might target lower long term interest rates by buying bonds if necessary in order to combat deflation. The corresponding data did and still does confirm the worry about deflation. The market had priced such Fed action against deflation into their valuation of bonds. The term for this was "special policy actions."

The Fed had bluffed the market to lower long term rates. At the last FMOC (Federal Open Market Committee) meeting a few weeks ago, the minimal 25 basis point rate cut combined with timid, even anemic, language made the markets doubt the commitment of the committee, and rates began to rise. Last week, I said that the market needed to hear Greenspan reaffirm that commitment to "special policy actions" if rates were to remain low.

Call and Raise

Not only did Greenspan not confirm the speeches, he basically shot down Fed governors Bernanke, et al, and said the committee had met and decided deflation was possible, but the chances were remote. In any event, the best defense was low short term rates, and he indicated a willingness to cut short term rates further. (There have been persistent rumors today that money market fund managers had to be given shock therapy in order to get them out of the comas they immediately went into.)

On any given day, 99% of investors do nothing. They neither buy nor sell. It is the 1% "on the margin" that control the movement of the price. On Tuesday, the 1% who had made a profit in the "carry trade" by borrowing short term money and investing long decided to throw in the towel. They could no longer count on the Fed to make that trade profitable. These (mostly) hedge fund and global macro fund traders had made a profit and decided to take their money and go to the next deal. "Thank you very much, Alan, see you next trade. Call us again when you are ready to guarantee us a profit."

Yes, I readily admit there were those who believed the Greenspan spin. But I would contend they were already true believers. They had already sold all the bonds they were going to sell. What self-respecting trader was waiting for a Greenspan speech to give them their true compass on the economy? Fed policy, maybe. But not the economy. Greenspan's record of late has been, well, bad.

Where was the quote from a real honest-to-Pete trader that said, "You know, I listened to Greenspan's testimony. Damn, he was persuasive. I loved his clear and precise logic and the way he marshaled his facts. I bought his forecasts (to a bunch of politicians, no less) hook, line and sinker about the economy and decided to change my investment forecast on the spot."? You didn't read one? Neither did I.

This is because real traders no longer buy Greenspan's rhetoric. This note from Art Cashin's daily letter came in as I am dashing for the plane, but it so illustrates the point it simply must be put in this week's letter:

"The Role Of The Cheerleader And The Limits Of Fed Communications - No one kids more about Fed Speak than Chairman Greenspan. He jokes that the role of the Fed Chairman is to be purposely obscure. But it is not obscurity but a lack of transparency that hobbles the markets relationship with the Fed.

"We thought we would examine some examples of Fed statements. Here are a few excerpts from Greenspan's testimony to Congress:

"'Nevertheless, the fundamentals are in place for a return to sustained healthy growth. Imbalances in inventories and capital goods appear largely to have been worked off; inflation is quite low and is expected to remain so; and productivity growth has been remarkable strong, implying considerable underlying support to household spending.....'

A little later he said:

'Household spending held up quite well during the downturn and through recent months, and thus served as an important stabilizing force for the overall economy.'

And later:

"'Monetary policy also played a role by cutting short-term interest rates, which helped lower household borrowing costs. Particularly important in buoying spending were the very low levels of mortgage interest rates, which encourage households to purchase homes, refinance debt and lower debt service burdens, and extract equity from homes to finance expenditures. Fixed mortgages rates remain at historically low levels and thus should continue to fuel reasonably strong housing demand and, through equity extraction to, support consumer spending as well. Indeed, recent sizable increases in home prices, which reflect the effects on demand of low mortgage rates, immigration, and shortages of buildable land in some areas, have significantly increased the equity in houses that homeowners can readily tap through home equity loans and mortgage refinancing.'

"That's what Alan Greenspan said - but he said it in his testimony a year ago.

"If the Fed is optimistic on a recovery it is because it has to be optimistic by its role. Mr. Greenspan could no more suggest that the Fed was pessimistic - or even stumped - than he could suggest a shift to communism. One of the senators recited a litany of Fed projections of levels of economic activity. All of them were later revised down. Mr. G. smiled and shrugged that projections of anything are rarely accurate. That's true. But....why always on one side? Because that's the role of the Fed. That's why a large grain of salt is in order.

"The potential difficulty, however, is that if people come to believe you are always postured one way they will not put much weight in your statements. Worse....if they think you are in control and you keep missing your targets, they may doubt your effectiveness. Better to be obscure."

These traders on the margin were not interested in spurious Greenspan forecasts that may or may not be real. They were interested in Fed policy and the implicit guarantees they thought they had. Pure and simple.

And so, long term rates shot up. Ten year bonds are at 4% as I write, though they have backed of some. This was from a low of 3.07%. Quite a rise in a few weeks.

I cannot believe that Greenspan did not realize the effect his words would have on the market. They cannot be that naive. They clearly must feel that a rise in long term rates will either be temporary, modest or will not hurt the economy. I am not persuaded. I think it is entirely possible that we will look back at this week's testimony and decide this was one of the poorest decisions by a Fed chairman in a very long time. I hope I am wrong.

Are Deflation Worries a Thing of the Past?

Richard Russell, one of my personal investment writer role models, is turning 79 on July 22. Six days a week he writes some of the more lucid and insightful market commentary on the web, and has been since 1958. At $250 it is a bargain for the wisdom contained therein. ( When I am 79 I hope I can write half as well. Heck, I wish I could write half as well at 53. Happy Birthday, Richard.

We are both not convinced that Greenspan has driven a stake through the deflation vampire's heart. Maybe Greenspan (and more recently Volker, who said the chance of deflation is 0.1%) has done it. But what if his view on inflation proves to be as right as his opinion about a second half recovery has been for the past two years?

Let me quote Russell:

"As I see it, the US (and the world) are now dealing with two momentous forces.

"One is the 'natural' force of deflation, which has followed the bursting of the greatest financial bubble in world history.

"The other force, the opposing force, is the all-out effort by central banks to counter the forces of deflation.

"The forces of inflation? I'm going to list them again -

"Globalism -- the fact that the world's markets are now open and actively competing with each other.

"The Internet -- I don't buy anything over ten bucks unless I check for competitive (lower prices) on the net. Wal-Mart, which has become an absolute killer in the retail field.

"China and India -- China alone could supply the whole world with merchandise at cut-rate prices. India has become a major factor in software and tech and cut-rate prices.

"Over-production -- Every nation has become a producer. The US negative trade and negative current account balances have loaded the rest of the world with a flood of dollars. These dollars have allowed the rest of the world to build up their production facilities. As a result, the globe is choking on over-production, meaning that the world is producing more goods than it can absorb. This has killed pricing power.

"...The question becomes -- why would deflation be so dangerous? Why is the Fed so panicked at the very thought of deflation?

"Two reasons: one -- if actual deflation takes over, the Fed loses its power to manipulate. Deflation can take on a life of its own, with declining prices causing consumers to wait for still-lower prices. In other words, in real deflation the consumer's psychology of 'let's buy' changes to - 'Let's wait.'

"Secondly, if deflation hits, then debt looms larger and more difficult to carry. This nation operates on the 'fractional reserve system,' and if deflation hits and consumers halt their buying and borrowing, the money supply begins to shrink and the whole system starts to work in reverse.

"I might add that this is not a normal economy. The US economy is up to its ears in debt, with a commonly accepted figure being that there's roughly $38 trillion in debt built into the US economy. If deflation hits, this tower of debt could become a financial nightmare. It could take on a domino effect and one layer after the next would be crushed by the need for financing, financing that becomes almost impossible to obtain in a deflationary environment.

"So that's the big picture as Richard Russell sees it -- the battle of the monsters, the battle of 'normal post-bubble collapse' deflationary forces against the inflationary capabilities of the central banks and more specifically the US Federal Reserve."

I would add that the competitive currency devaluation that is clearly going on is making a potential deflation problem worse. As recently as last night, Japan made aggressive, albeit more or less futile, efforts to push the yen lower. The euro is dropping as European leaders demand a lower currency.

Rising interest rates threaten to cut into what momentum the US economy has. While I do not smoke from the same pipe as the Fed economists, I have not been bearish on the US economy. I simply see a Muddle Through Economy of 2-3% growth for the next few quarters. Maybe a quarter of above 3% (or even 4%) growth now and then, but on average under 3%. Not bad, but below potential.

(This morning Ford tells us their economists see no second half recovery, or even one beginning next year. That is the difference between economists who must work in the real world and those who get to sit in Ivory Towers.)

The one "asterisk" to my Muddle Through scenario is higher long term interest rates. This economy is very dependent upon housing construction and home prices which allow for equity loans and refinancing. To Greenspan, this is evidently a good thing. To me, it just is. If someone wants to borrow on his home, I expect him to be a big boy (or girl) and capable of assessing his/her/their own personal situation.

But higher rates at some point will clearly stall the process. It won't kill it. It is not like we fall off a cliff. It simply slows the trade "on the margin."

But the margin can make a big difference. The difference between where we are today and a recession is less than 1.5% GDP growth. A small slowdown in housing and consumer spending and that could happen quickly.

Are rates at the current level enough to do that? Candidly, I think not. These rates were considered low just a few months ago, and were buoying the economy. While they are not as "stimulative" as the rates almost 1% lower a few weeks ago, they are still quite low historically.

The 6/50 Rule

But how likely are they too rise from here? Ahh, that, dear reader, is what we explore next.

Once again, good friend and researcher Ed Easterling of Crestmont Research presents us with a brief set of charts which shows the historical volatility of the bond market. You can go to, click on interest rates and then scroll to the bottom of the page and click on the 6/50 rule to see the charts I will briefly discuss. The principles they illustrate are very important to your understanding of bond prices and interest rate moves.

The summary Ed gives is as follows:

"In the past 35 years (with a two-month exception), there has not been a 6-month period during which interest rates did not change at least 50 basis points-interest rates are much more volatile than most investors realize. As history demonstrates, more than half of the time, interest rates change by more than 1.5% (and over 25% in percentage terms) over all 6-month periods. This set of charts and statistics (a total of five pages) presents the data and a boundary guideline that can be expected to be crossed before the end of 2003."

OK, let me summarize the charts. First, Ed went to the Fed database and downloaded all interest rates for the last 35 years, from short term to long term. What he found was that:

"Over the past 35 years, interest rates have moved more than 50 basis points (+/- 0.50%) at some point across the yield curve during every subsequent six month period (except following the first two months of 1998).Based upon the history of interest rates, at least one interest rate point along the yield curve can be expected to exceed the upper boundary or lower boundary within the next 6 months (before the end of the year)."

In actuality, more than 82% of the time, the movement was in fact greater than 1% and was more than 1.5% more than 50% of the time!

Boring old bonds are anything but stable. Volatility, thy name is bonds.

Now, the caveat to this is that the movement did not necessarily take place all along the yield curve. It could happen on either short term rates or long term rates (or both). But the research shows that SOMEWHERE rates moved more than a minimum of 50 basis points, either up or down.

The observant reader (of which you are no doubt one - I have no other kind) will note that 50 basis points in 1980 when interest rates were 15% or more was nothing. "So what does that statistic really mean?" you ask.

Let's look at the moves in percentage terms. 65.8% of the time, the move was more than 20%. That would mean a rate of 4% would expect a change of 0.80% almost 2/3's of the time. That is still quite a significant chance for a significant move.

Let's look at what History might tell us about future interest rate moves. First, somewhere along the yield curve, interest rates are going to move 50 basis points from where we are today. Since the Fed (Greenspan) virtually guaranteed short term rates to remain low, one would expect that means long term rates will move.

Which way? Up or down? Ten year rates are at 4%, give or take. Thus, we would expect either 3.5% or 4.5% to occur within 6 months. Given the recent movement and Greenspan's inexplicable statements, one would suspect up. That would take 10 year rates to 4.5% and suggest a 30 year mortgage rate of 6.5%.

Sport fans, I think 6.5% mortgages is potentially a deal killer. The consumer starts to look over his home equity shoulder. Re-financing, which is more than a small part of the consumer spending number, is DOA at 6.5%. At that point, the housing market begins to roll over. That number potentially pushes us into recession.

This is compounded by the tax impact. Dennis Gartman writes today and tells us about a downside to the good news of tax cuts (which we both love). The increase in the standard deduction combined with lower interest rates means that:

"...given the decline in interest rates that has driven mortgage rates to the levels they are presently, an average married couple, taking out a 5.5% fixed rate mortgage for 30 years, needs now to have a mortgage of $190,000 merely to meet the standard deduction they are already granted under the law. This is a leap we are not willing to expect the average married couple to make, perhaps putting downward pressure upon housing prices, or at least taking the upward pressure off, as they realize that their 'tax benefits' have been chopped materially. In the long run, this is good for the economy, for housing driven by tax consequences is bad housing; but in the short run, and as this becomes more commonly understood, the urge to buy likely has been reduced... if not materially... at least somewhat."

Rising inflation supposedly makes people buy sooner rather than later in order to lock in lower prices. I suspect rising interest rates could have the same short-term effect. If you were planning to buy a house in December, it might seem a better idea to buy now why rates look to be lower.

Mortgage rates at their current level are no deterrent. Indeed, they are a stimulus. But if you think rates are going up? You push forward your plans to buy. Thus, housing starts and sales are up. The housing industry is fine today. It could even see a spurt as people rush to lock in what they feel may be the "Last Train Out."

Will long term rates rise another 50 basis points or more? Will History repeat? There were seven weeks that were an exception to the 6/50 rule. But that is cold comfort, as those weeks were in early 1998. They were followed in the summer and fall of 1998 by a period of interest rate volatility that most bond traders liken to a hundred year flood. It was brought on by the Asian currency and Russian bond crises, triggered by Long Term Capital.

Now we find another Asian country having a bond melt-down (Japan, which Daiwa Research today revealed has a corporate pension funding problem larger than our own) and bonds markets world wide being roiled; currency valuations in serious flux as countries fight to keep their currencies competitive; debt at nosebleed levels; a US stock market at high valuations; a US economy on the mend but sending "mixed" signals; and, Europe and Japan, Korea and many of our trading partners suffering through the beginnings of recession.

That is not a cocktail mix for stable interest rates. What can we expect in the short-term? I rather expect rates to rise, but the question is how much. Pamela and Mary Anne Aden, the Costa Rican Wonder Sisters, are well-known in investment circles for their technical trading skills. In their alert of yesterday, they wrote:

"Bond prices fell yesterday following Greenspan's comments that the economy is poised to accelerate. But he also said interest rates will stay low as long as needed. The 30 year yield shot up, as it approached its major downtrend, and its five week rise is now the most overbought it's ever been. It's clearly at an extreme on a short-term basis. This means the major bond price trend is still up and further weakness will likely be limited. Bonds, however, may be forming a top as the yields are closer now to their major trends than they've been in a year. Watch the major trend. If the yields close and stay above 4.98% on the 30 year and 4.10% on the 10 year, the major bond price trend will be turning down and we'd then recommend selling your bonds. But if the 30 year yield closes below 4.70%, the five week bond decline will be over and we'd then recommend buying bonds. Overall, it feels like bonds still have life in the bull market."

History says long rates are going to either rise or fall by at least 50 basis points in the next six months. They could easily do both, as a rise too far, too fast could choke off the recovery, creating the conditions for a deflationary period or even a lapse back into recession if rates rise high enough. Ironically, that would mean a lowering of long term rates, not only from the Fed but also from market forces.

Don Peters of Central Plains Advisors, has been in the top 1% of bond timers and managers for the last 25 years (as rated by Callan and Associates, who keeps up with such arcane trivia). He has gone back 100% into long bonds, as he is convinced that deflation is not dead, this rise in rates is not backed up by fundamentals and that rates, even if they go higher, are eventually coming down.

It's a gutsy call, but I think he is right. The irony is that the higher rates go on this cycle, the lower they will go on the next. I still contend we are one recession (whenever that is) from the ultimate bottom of the bond market.

Leaving on a Jet Plane

Dashing for the airport, Paris host Bill Bonner tells me it is 100 degrees in Paris and his chateau home in d'Ouzilly. Unlike sensible Texans, who understand heat, he notes most French establishments and homes do not have air conditioning, as there is normally little need. Oh, well, out of the frying pan....

As you read this, I hope to be sipping wine and solving the problems of the world, or at least pondering which problems are really worth discussing. I will be meeting with a number of European investors and businessmen. I have not been to Europe since before the Millennium. It will be interesting to see the differences. I will report back in next week's letter.

I still have one opening for a meeting in Boston on Monday, July 28. Have a great weekend and take time to relax and enjoy an adult beverage with your friends and family, as they are the best answer to life's little problems.

Your wondering how is he going to stay on his diet analyst,


John Mauldin

Author: John Mauldin

John Mauldin

John Mauldin

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