The Greenspan Conundrum
by John Mauldin
May 27, 2005
Paul Revere and the Monkees
Tiny Bubbles Here and There
Exactly What Inflation Are We Talking About?
The Three Amigos
Is That A Bell I Hear?
Can the Fed Find the Sweet Spot?
Paris, Ouzilly, London, New York, etc.
"There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross- border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience." Alan Greenspan, before Congress, February 16, 2005, (my emphasis)
Interest rates are now the topic du jour around water coolers and in happy hours across America. Every group has at least one person who knows the answer. If there are two people who know the answer they are almost guaranteed to disagree, unless one of them is the other's boss. I am less certain about the answers, but nonetheless this week will proffer an idea or two.
In the above quote, Alan Greenspan noted that the low interest rate yields on the long bond were a "conundrum." Since then other Fed governors weighed in that low rates are a "puzzle." Of course, rates have dropped even more on ten year bond, which I am sure is furthering the bewilderment of the Fed, not to mention bond bears and those who believe a new bout of major inflation is around the corner.
We will look at possible scenarios for the bond market, the potential for a new wave of refinancing, housing bubbles and a lot more. There is a lot of ground to cover, but first we have to cover a far more important topic, at least judging by my mail. Paul Revere and the Monkees
Last week at the beginning of my e-letter I quoted a line from the song Kicks, to the effect that "It seems like kicks just keep getting harder to find..." I then sourced that song as coming from the Monkees. It was only a few hours after sending the letter that Chuck Butler of Everbank (very early Saturday morning) first noted that it was not the Monkees but Paul Revere and the Raiders. Over the next few days we got hundreds and hundreds of emails noting my "mistake." We are used to getting a lot of responses, and try to look at each one (and sometimes respond), but this was the single biggest response on one topic ever. Clearly I had touched a baby boomer nerve.
Web sites and blogs took notice, and there was a long string on Richard Russell's web site where someone (quite funny, I thought) noted that I was clearly hitting Muddle Age. I normally am not sensitive to those who point out my foibles and wrong ideas, of which there are both many critics and foibles from which to choose. I try and learn from each and everyone (well, maybe not the nut jobs), but I feel here I must defend myself.
I feel somewhat like Dan Quayle. Do you remember that famous spelling bee? The one where he asked a kid to spell potato? The card in front of him incorrectly had potato with an "e" on the end of it (potatoe), and when the kid spelled it correctly, he looked at the card and told him he was wrong. He knew better, but who would argue with a card given him by the teacher?
The press never let him live it down. Interestingly, I met him a few years later and had a long private meeting with him and a few other businessmen. I was more than impressed with his intellect and grasp of policy. He was completely different than the person I expected from his press coverage.
I do try and check my quotes and my memory. This time I went to Google, typed in the phrase "Kicks just keep getting harder to find" and the very first site was: http://www.monkees.net/DOCS/LYRICS/kicks.htm
. I thought that sounded odd, but who could argue with the official Monkees web site? Especially on a deadline? Especially with a Mavs game in a few hours? (Which they sadly lost.)
I should note that on last Friday afternoon nowhere on the first page of Google was there a reference to Paul Revere and the Raiders. Evidently the Monkees also recorded Kicks, although I will confess to not remembering that album. Google has since conspired to put many references to the Raiders and Kicks above the Monkees site. Oh, well. The good news is that there are a lot of readers who actually pay attention to the details. So, thanks. And now back to the less exciting topic of interest rates. Tiny Bubbles Here and There
Greenspan recently noted that while he is of the opinion that the there is no housing bubble in the overall United States, there may be small localized bubbles here and there. Numerous Fed governors have also recently been talking about the potential for an overheating of the housing market. It is clearly on their mind. They are worried that a housing bubble may indeed appear due to low rates and speculation. Having just come through the deflation of an asset bubble in the stock markets, they do not want to have to deal with a second bursting bubble. Especially given that they used most of their deflation-fighting bullets dealing with the last bubble.
The conundrum that Greenspan speaks of has to do with the fact that the Fed has raised interest rates by 250 basis points and long term rates have actually come down. Rather than higher mortgage rates acting as a natural deterrent to a potential housing bubble, rates are encouraging speculation and a continued rise in housing prices.
(You also wonder that a Fed Chairman seems to be lecturing the market rather than listening to it, but that's another topic for another letter.)
The Fed has virtually guaranteed us two more rate increases of 25 basis points, which will take the Fed funds rate to 3.5% by the end of the summer. The questions we visit today are:
Will the Fed raise rates further than 3.5%?
If they do raise short-term rates, will it have any effect on long rates?
If the Fed raises rates too far can they choke off economic expansion, and even worse, bring about a slowdown or a recession?
If they do too little or nothing will inflation return?
Is there anything they can do about rising housing prices?
Is there a recession in our near (2006) future?
In order to try to get some answers let's look at a few facts and observations.
Last week, I touched on the fact that Bill Gross of PIMCO believes that the yield on the 10-year T-Note will fall to 3%. This week, David Rosenberg, the chief North American economist for Merrill Lynch joined the bond bulls with a rather startling announcement. As recently as April 1 (eight weeks ago) he expected the 10-year T-Note to rise to 4.65% by the end of the second quarter, and fall to only 4.4% by the end of the year.
He now projects the 10-year bond to drop to 4.10% by the end of the year and 3.8% in the first quarter. He also thinks the Fed will stop raising rates at 3.5% and will actually begin to cut rates in the first quarter of next year back to 3%.
Let's think about what that would mean for mortgage rates. One of the links I save in my "favorites" is http://www.bloomberg.com/markets/rates/index.html
. It is an up-to-the-minute quote of interest rates of all types. Today we find that 30 year mortgage rates are about 1.15% over the 10-year bond. Sometimes it is more than that, sometimes it is less. If Bill Gross is right we could see mortgage rates in the neighborhood of 4%. If Rosenberg's projection is correct, mortgage rates will certainly drop below 5%. In either case, you would have to think such low rates would precipitate a new round of mortgage refinancing.
Since I have contended for years that we are in an overall disinflationary environment, projecting lower interest rates is something that I am quite comfortable with.
There is a growing chorus of market observers who believe that the Fed should stop raising rates sooner rather than later. Rather than looking upon the first quarter's very respectable 3.5% GDP growth rate, low and falling unemployment, healthy corporate profits and a surprising growth in tax receipts at all levels (which means personal income is rising), and seemingly slower inflation, they look at other figures and worry.
Lacy Hunt, of Hoisington Management, tells me that the Leading Economic Indicators from ECRI are now down year-over-year. This has happened 10 times in the modern era, and we have had seven recessions and two serious slowdowns following those events. (The other was during the Iraqi War and we had massive stimulation after a recession. No such future stimulation is possible.) Further the OECD's world leading economic index is down from projecting 7% growth to only 0.1%, a rather dramatic drop. It will probably go negative when we get the data in April.
Let's make no mistake about it: the Fed is putting on the brakes. Growth in the money supply is almost non-existent. Some observers like Dennis Gartman focus on the monetary base or MZM, which is actually down over the last four months. Others like Lacy Hunt prefer to look at a broader monetary base of M-2. He noted to me in a conversation today that year-to-date growth in M-2 is only 1.6%. Since 1900 the averages have been around 6.7%, which coincidentally is exactly the rate of nominal growth of GDP over the last 105 years. If the money supply does not grow fast enough you choke off growth. If it grows too fast you risk inflation. Right now growth is at a nine-year low. They are clearly choking growth.
The Fed is not only tightening the money supply, it is tightening lending standards on mortgages. In a press release on May 16, the Fed, in conjunction with the FDIC, the OCC, the OTS and the NCUA (all agencies which have oversight of lending institutions), announced new guidance procedures for home equity lending. They specifically noted the following risks:
Interest-only features that require no amortization of principal for a protracted period;
Limited or no documentation of a borrower's assets, employment and income;
Higher loan-to-value (LTV) and debt-to-income ratios;
Lower credit risk scores for underwriting home equity loans;
Greater use of automated valuation models and other collateral evaluation tools for the development of appraisals and evaluations; and
An increased number of transactions generated through a loan broker or other third party.
No kidding. You think concentrating those types of loans in a portfolio might create some risk for a lending institution? During the stock market bubble the Fed failed to use the administrative tools which they had in their possession. They could have raised margin requirements but failed to do so. It appears they have learned from their mistake (more on this learning process later). Exactly What Inflation Are We Talking About?
The Fed in its last minutes noted that inflation pressures seem to be waning. Merrill Lynch notes that "80% of the increase in inflation cycle, which began in November 2003 came from only two sources: 1) the dollar and, 2) commodity prices." Gave-Kal openly worries that the latest move toward higher inflation is temporary. They make the following important notes:
"...since 1990, the collapse of the communist system and the end of the Cold War, things have changed. Specifically:
There is now a strong downtrend in prices
The growth rate of US CPI seems to be capped at 3%
US CPI does not really accelerate with global economic activity
US CPI falls precipitously when economic activity decelerates
"So in a sense, we are now facing an asymmetry in prices (typical of deflationary periods). In each economic slowdown of the past fifteen years, US inflation fell by 1-2%, while in periods of economic expansion, US inflation failed to make new highs. And where does all this leave us today? Today, the US median CPI is above its trend, a position which, in the past fifteen years, was a time when inflation would start to decline... but only if global economic activity slowed.
"So what are the prospects for global growth? ....According to the OECD, global industrial production could very well be declining by the end of the year. So, the conclusion is inescapable: global growth is weakening. Will US inflation consequently roll over?
"...Today something odd is happening. By all historical measures short rates are still very low. And yet, the rate of US money growth is collapsing.
"As Milton Friedman famously stated, and as History has proven time and again, a central bank can control only one thing at a time. It can control an exchange rate, short interest rates, or the growth rate of money supply... But not all at once. In the case of the Fed, the tool of action is usually the Fed funds rate. When the policy is very "easy", one would expect to see a large increase in the US monetary base (the central bank money stock). Indeed, at the perceived very low rates of interest, the financial sector comes in and borrows happily to distribute credit in the economic system. This also usually leads to a collapse in the exchange rate. Similarly, when the monetary policy is perceived to be very tight, the monetary base growth rate will implode, and the exchange rate will rise.
"Along with the very weak growth in the US monetary base (which argues for lower inflation in a few quarters), we find that: a) the US$ is rallying, b) commodity prices are falling, c) credit spreads are widening, d) gold shares and gold prices are weakening... All signs that the US monetary conditions are now tight!
"Asked about the difference between pornographic and erotic material, a US supreme court justice famously answered: "I know pornography when I see it." By the same token, it can be argued that the markets know when the Fed has pushed short rates to, or even above, their "neutral level". At such times, we start to witness all of the things we have witnessed in recent weeks (US$ rally, weakness in gold, slowing global activity, etc...). Given the Fed's History of listening to the markets, the Fed is probably close to done in its tightening cycle."
Paul McCulley of Pimco argues this week that the Fed always stops raising rates when the ISM manufacturing numbers turn negative (meaning they go below 50). He shows a very compelling chart at www.pimco.com
. Click on McCulley's latest essay, which is a must read. We are starting to see early signs of a manufacturing slowdown, which means that below 50 number could happen soon rather than later (more below). He, too, thinks the Fed should start thinking about sitting still.
There are signs that inflation may be receding. Import price data for April was up only 0.1%, ex-energy. Capital goods prices have actually been down for the past three months, and stripping out food end oil prices are only up 1%. Now I know that oil and food are important, but the point is that a stronger dollar and a flat energy market are not the substance of inflation without other pressures, and there seem to be none.
The 3 month trend in the Producer Price Index is now at only a 2% annual rate. Capital goods are only rising at a 1% rate. The monthly reading for core CPI (consumer price inflation) took the year-over-year rate down to 0.2%. (Merrill Lynch) The Three Amigos
Long time readers know I like to look at a set of statistics I call the Three Amigos to get a sense of the direction of the economy. They are all now showing signs of stress. Amigo #1 is capacity utilization. After rising for some time, it has started to back off. Cap-U rates for finished goods has dropped from 77.1% in March to 76.7%. This is abysmally low for an expansion (it should be pushing 82% by now). This may help explain the lack of pricing power as well why rates are so low. Why borrow money (demand for loans and thus a push upward on rates) if you can already produce what you need with what you have? But a fall- off in Cap-U is not a sign of a growing economy.
Amigo #2 is High Yield Bonds. They are starting to look more than a little toppy as credit spreads are starting to move out. In a world desperate for yield, as proven by how low junk yields have gone, this is a sign investors are worried.
Amigo #3 is the ISM manufacturing number. I like to look at both the actual level of the number and the direction. If the number is above 50 it means there is growth in manufacturing and if it is under 50 manufacturing is slowing. Since hitting a high of 62.8 in January of 2004 (an excellent number) it has slowly and steadily dropped to 53.3 last April. The trend is not good. We will see the May data this Wednesday, and looking at other mid-month manufacturing figures, it looks like it will be lower again.
These all suggest a slowing economy. Mortgage applications are dropping, consumer sentiment polls (take your pick) are weakening, and consumer sales seem to be slowing in May, especially in automobiles. Is That A Bell I Hear?
Of course, housing sales and prices are off the charts. This week's Fortune Magazine highlights a number of real estate speculators who are buying homes in hot markets, often without even seeing them. Richard Russell noted this week that there are almost as many real estate agents in California as there were houses sold last year. I am told that the Playboy May Playmate is quitting her modeling career to go into real estate. (I know they say that nobody rings a bell at market tops, but the latter does make a certain distinct bell like tone.)
So, let's sum it up. The Fed is tightening and monetary policy may already be tight. I won't take the time, but there are some very solid arguments that the Fed is either at of past the so-called neutral rate already. The neutral rate is that mythical point at which interest rate policy is neither accommodative nor tightening. No one knows exactly what level the neutral rate is. But the Fed more or less seems to accept the Taylor Rule (a way to figure the neutral rate), which would imply they can continue to raise rates without slowing the economy.
Those who disagree suggest the Taylor rule should not apply under today's conditions. That means any rate increases are taking us further into tightening territory. Given that the money supply is going flat-line makes me tend to agree.
The Fed has signaled they will raise rates at the next two meetings. That will mean short rates will be at 3.5%. If ten year rates drop to 3.8% in the first quarter, the yield curve will be very flat indeed.
Typically, the Fed goes to far when it raises rates. If they continue to look at the Taylor rule as their guide, they might very well indeed go on to 4%. History certainly would suggest they will keep right on raising up to 4% or more. Remember them raising rates in 2000 as the stock market imploded? The bond market was clearly signaling that things were slowing down and the Fed paid no attention. The yield curve inverted and we had a recession.
Have they learned anything? Maybe. They are using administrative procedures to slow down the pressure on too easy loans. Maybe this time they will listen to the markets and stop hiking like McCulley, Rosenberg and others suggest.
Can the Fed Find the Sweet Spot?
For what it's worth, I think we are in a very delicate position. Can the Fed find the sweet spot? In this tightening process, can they slow down the rise in home prices without actually popping the local tiny bubbles, as well as some areas that are not bubbles? Can they avoid tipping the economy over into recession? Will rates drop low enough to allow that huge number of people who got Adjustable Rate Mortgages in 2003 to re-finance without causing harm to their cash flows? Can they avoid inflation dropping too low as we go into a possible soft spot, which is what lower long term rates imply?
For what its worth, Rosenberg thinks CPI will drop to 1.5% by the first quarter of next year. He also thinks the Fed will cut rates at that time back to 3%. That may not be enough if we are truly entering a slow patch.
Remember, the #1 enemy of a Fed governor is deflation. When they are appointed to the Fed, they are taken into a back room where they get a DNA change, after which, they are viscerally opposed to deflation in all its forms. If inflation gets too low before a recession, it will take a mighty effort in this slowing world economy to stave it off. While we definitely will not like the disease (deflation), we will not like the cure (aggressive reflation). As my Dad used to quip, "The operation was a success, but the patient died anyway."
I can definitely see a potential that we go into a soft patch, and like 1966 or 1995 we get a soft landing. Low long-term rates spur another round of refinancing, which we know is a powerful stimulus. Corporate balance sheets are in good shape, so they can weather a small storm. But I think the crux of the matter is whether the Fed stops the hiking and money tightening cycle soon.
But I also see the potential for a recession. The signs are beginning to suggest a slowdown at a minimum. I worry about the money supply growth. Flat growth for this long is NEVER a good sign. The Fed needs to take their foot off the brake. They also need to take heed of the market. We need to hear some Fed governors talk about the possibility that we are near the end of the tightening cycle. Until someone starts giving that signal, you have to assume they will continue to tighten. Taking rates to 4% in this environment would be a potentially big mistake. I think the bond market is clearly giving that message to the Fed. Will they listen?
It is too early to tell. We need to start watching the money supply numbers more carefully, as well as economic indicators. Especially critical will be the ISM numbers this week and next month. If they continue their trend downward, it bodes ill for the economy, but will strongly suggest to the Fed they need to stop the tightening cycle.
Opening the door to my worry closet, I am concerned we could enter a potential recession with low inflation and low rates. That will force the Fed to use unconventional weapons to fight deflation. Long time readers know that I have been worried about this for years. We may now be entering the period where we see if there is any substance to my fears.
There are so many other factors to consider: trade deficits, currencies, foreign central bank funding, China GDP, the savings rate, the stock market, etc. Each is a piece of the puzzle, but it is time to hit the send button. Paris, Ouzilly, London, New York, etc.
This summer promises to be a memorable one for the Mauldin family. I am taking my seven kids and one daughter-in-law to Paris for four days, then onto my good friend Bill Bonner's chateau (the French word for money pit) in the south of France (Ouzilly) for four days, fly to London for four nights and then a day in New York and home. The cool thing is that the whole trip is only costing a few thousand plus food. How, you ask? I have enough air miles for most of the trip (although Dad will have to fly coach this time - ouch) and I have not used my Marriott or Hilton points for 15 years. I have to buy a few extra hotel nights, but that is all.
Bill (and Elizabeth) are likely to have their six kids there as well, plus a few other guests. But there is plenty of room. We have wanted to get the kids together for some time, and I have wanted to take my youngest five kids (really, young is relative - 24, 20, 20, 16 and 11) to Europe for their first time.
Tomorrow is my youngest son Trey's birthday. He will be 11. They grow up so fast, but I have found the older they get the more fun they are, with a few year's exception. They all seem to have a few painful years in the process, but we get through it.
And speaking of travel, my friends at International Living have a new offer if you are interested in learning about living overseas. http://www.agora-inc.com/reports/IL/WILVF532/
It will be a great weekend. Ball games, parties and Star Wars, a few workouts and lots of family. The Rangers just beat Chicago and are in first place and on a seven game winning streak. It is quite distracting to write this letter during a game, as I get up and go out on the balcony to "take a back break." But I got up at the right time this game. Fifth inning saw back to back two-run homers. Maybe we will have a play-off game in Texas. It could happen.
Have a great weekend and spend some time with family and friends. It is an investment that always pays big dividends.
Your watching the Fed (and the Rangers) analyst,
John Mauldin JohnMauldin@InvestorsInsight.com
Copyright 2005 John Mauldin. All Rights Reserved.
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