Another edition of our new series: Blog Spotlight.
We put together a short list of excellent but somewhat overlooked
blog that deserves a greater audience. Expect to see a post from a
different featured blogger here every Tuesday and Thursday evening,
Next up in our Blogger Spotlight: James Picerno is the editor of The Capital Spectator (capitalspectator.com), a blog focused on economics and investment
strategy. He is also a senior writer for Wealth Manager, a trade
magazine for financial advisers to wealthy individuals. He has been a
financial journalist since the late-1980s.
Today’s focus commentary looks at:
The head of the self-proclaimed "authority on bonds" says the rate hikes are history. PIMCO’s Bill Gross wrote in his October Investment Outlook that "the Fed is done and ultimately will have to lower interest rates in order to restimulate an asset based/housing led economy that has been its primary growth hormone in recent years."
The underlying assumption in his projection is that inflation is "leveling off" and the economic growth rate is "moving towards a 2% real growth rate or less in the next year or so…." As such, the Fed "at some point in 2007 will be forced to cut short rates." Timing and magnitude are yet to be determined, he adds.
In fact, the future may be more complicated than it appears. Economist Robert Dieli of NoSpinForecast.com documents the finer points of this complexity by plotting the history of economic cycles against instances of inverted yield curves. As he illustrates in the chart below (which, alas, we’ve squeezed a bit from the original to fit into the confines of CS), there’s a lengthy history of yield-curve inversions accompanying economic contractions and a drop in the Fed funds rate shortly after the yield inversions arrived. But that doesn’t mean the past is prologue, at least not a prologue that’s clear and obvious.
Federal Funds Rate. Red Squares Denote Periods when the Fed Funds
Rate was Higher than the Long Treasury
In any case, the last example of rate hikes and recession came early
in the 21st century, identified on the above chart by "11." The red
dots indicate moments when Fed funds were higher than the Long
Treasury, defined here as the 20-year Treasury. As Dieli noted in the
accompanying research report, "There are no cases of a yield curve
inversion ending without a drop in the Fed Funds rate from the peak
level attained in each episode."
(As a quick digression, the two red dots between episodes 10 and 11
were, Dieli told us this morning, were byproducts of the anomalous
events associated with the implosion of Long Term Capital Management and the Treasury’s decision to stop selling the 30-year.)
Ah, but what about episodes 8 and 10? Note that the Fed funds took
flight in each of those cases without a commensurate yield-curve
inversion, suggesting, if nothing else, that sometimes the central bank
achieves something close to perfection in monetary policy. Indeed, in 8
and 10, long rates took wing but without triggering a yield curve
inversion or recession.
Episode 10 is near and dear to investors’ hearts. The moment came in
1994, when then-Fed Chairman Alan Greenspan elevated rates and
delivered the much-sought-after but rarely delivered soft landing by
way of higher rates sans recession. It was, in sum, one of Greenspan’s
finer moments. As Dieli wrote, "In episodes 8 and 10, the two
successes, the yield curve did not invert, which allowed the FOMC to
lower rates to complete the implementation of a policy accommodative of
further noninflationary growth, thereby burnishing the reputations of
Chairman Volker and Chairman Greenspan."
We are now firmly in the world of Episode 12, which admittedly has
yet to fully play out. While the world guesses what comes next, there
is at least one absolute to consider: the yield curve inversion. Fed
funds today are 5.25% and the 10-year Treasury yield resides at a materially lower level of 4.63%, as of Friday’s close. Beyond that, clarity necessarily blurs.
Dieli worries that episode 12 may become episode 3, which, as the
chart shows, was a moment when the Fed had apparently engineered a soft
landing. In fact, the early signals were misleading. The central bank
hadn’t tightened enough to battle inflation, and so was forced to
reverse course soon after by raising rates once again, which led to a
The issue, as Dieli sees it, is that the bond market has no fear of
death at the moment. "I can’t imagine the bond market feels any
particular threat in holding long positions," he tells CS
today. The problem for Bernanke and company boils down to answering
this question, as put forth by Dieli: "How do you convince the bond
market that you’re done without starting a recession?" The history of
the past 20 years suggests that bringing down the core rate of
inflation requires a recession. Will that history hold? Or is something
new and relatively unprecedented waiting in the wings? The incentive
for answering "yes" typically comes from looking to globalization and
its accompanying byproduct: disinflation/deflation argument.
In any case, the final answer may not be imminent, but it’s coming. The only question is timing and magnitude.