Will They Raise or Will They Stay?

John Mauldin | Thoughts from the Frontline
April 23, 2004

With the theme song (circa 1979) from The Clash as our background music - Should I Stay or Should I Go? - we explore whether the Fed will raise interest rates this summer or postpone any actions until after the election. We look at a prediction by bond maven Jim Bianco, whose track record on these matters is quite good. He believes the Fed may raise rates as early as the June meeting. This seemingly arcane topic has important implications for your portfolio and the economy. It should make for an interesting letter.

But first, a brief update and commercial for my book, Bull's Eye Investing . I woke up Saturday to find it had risen to #1 at BarnesandNoble.com. It stayed there for the weekend and has been at #2 behind Woodward's book, Plan of Attack , after an appearance on 60 Minutes rocketed his book sales. Surprisingly to me, Bull's Eye went to #7 at Amazon.com over the weekend, and has been fairly strong. Last week, I told you that B&N had a 30% discount and gave you a link. Those clever guys over at Amazon gave a 32% discount even as my letter was going out. You can buy two books and get free shipping, which seems to me to be quite the deal. Click on http://www.amazon.com/bullseye. For those interested in what the book is about, you can go to http://www.absolutereturns.net and read the introduction to the book in the section titled book excerpts, which will give you a reasonable idea.

And many thanks to all of you who have already bought the book. The publisher has already started a second printing. Remember to let me know that you have so I can add you to my private Bull's Eye Update list, where I will send updates on various topics in the book every quarter or so. Simply reply to this letter and tell me you ordered the book. And now, let's get back to our regularly scheduled program.

Will They Stay or Will They Raise?

Last week, I noticed a graphic on CNBC while Jim Bianco was speaking, which said he expected the Federal Reserve to raise the discount rate at their June meeting. I quickly flipped on the sound and got the tail of his interview, but missed the first part.

Long-time readers know I am on record as to not thinking the Fed will raise rates before the election, for a number of reasons. I still hold that view, although the markets are decidedly disagreeing with me. And they may have some cause, as Greenspan's latest testimony seems to indicate they are preparing the way for rate hikes. As always the question has been when and not if they will raise rates. I still think the "bet" is for after the elections, but the facts could change forcing a rate hike earlier, and we should look at that possibility and the consequences which would come from a rate hike this summer.

To set the table for this discussion, here is the paragraph I wrote (rather flippantly, in hindsight) at the end of last week's letter:

"Jim Bianco said today he thinks they will raise rates at the June meeting. Jim, my friend, I will take that bet. In fact, I will raise and say not even in August. Next week we look at my reasoning. And it does make a difference as to how you position yourself."

The next morning I got a reply from Jim, noting that is not exactly what he said. I am going to give you his letter without editing so you can understand his reasoning. I readily admit that he could very well be right. He has been on the bandwagon for a more transparent Fed policy for quite some time, which I am in full agreement with. He also feels the Fed should let the market set rates rather than so clearly manipulate them. Again, I am in agreement. However, I think the Federal Reserve governing board does not share that thinking, and it is their view that counts as to when they will actually raise rates. It is normally not good for your track record to disagree with someone as smart as Jim, and he does make a strong case for the Fed raising rates in June. (I mentioned this to trading wizard Dennis Gartman this morning, before I told him I was going to disagree. He said something to the effect, "Disagreeing with Bianco is generally a career ending move." He just laughed when I said I was going to do it anyway.) Ok, let's jump in with Jim's letter:

"John, I said IF April's non-farm payroll report is greater than 200,000 (released May 7), the Fed will have no choice but to go. I reasoned that if they do not hike on June 30 (again in the wake of another strong payroll report), the CRB will top 300, gold will make new highs, the dollar will resume its downward trend and long-term interest rates will continue to soar (as they have since April 2). Further all these trends will continue until the Fed does raise rates.

"I suggested June as the Fed does not want to become part of the election rhetoric. Nothing short of a full-blown crisis will get them to do anything at the September meeting. They would prefer to do nothing at the August meeting. So, it's June or next year.

"Right now the July fed fund futures is putting the odds of a June 30 hike near 40%. One more strong payroll report SHOULD push the odds above 50%. This is why I'm looking at June 30. The track record of this contract looking out less than 3 months is pretty good.

"1% is an emergency rate set in the wake of September 11 and the Iraq war. The Fed reasoned the economy was in serious trouble because of these two events. The Fed was wrong. The economy is booming (6+% real GDP 2h 2003) and the consensus is expecting 5+% real GDP in Q1 2004. A year ago the economy was losing over 100,000 jobs a months. In the first three month of 2004, its been adding 171,000. Quite a turnaround.

"Its time for the Fed to move from accommodative to neutral . Right now, my reading of the "Taylor Rule" suggests "neutral" is near 4%! The current policy has created a substantial inflation worry (CRB, Gold, TIPS breakeven inflation rates at 5 year highs) and now when we have a significant bottom in core CPI fueling this worry. Friday, Al Broaddus said the Fed can continue "Patience" and suggested they need more evidence of inflation to hike rates. My sense is the marketplace is close to "losing patience" with the Fed. The marketplace sees inflation. The marketplace has been asking the Fed to move to "neutral" for months. The Fed is not listening! At some point happy talk about inflation will be viewed as just talk to justify a bad policy and add $10 to gold (or 10 points to the CRB) every time they suggest inflation is not a problem.

"IF we get more strong economic numbers, the markets will riot if the Fed doesn't take its foot off the gas. If the Fed does not move sooner (i.e., June), the market will worry the Fed is "locked out" until after the election. This means inflation, and leveraged speculation in the bond market will run unchecked for months. Leveraged speculation, I might add, that has been largely caused by 1% funds and statements like "considerable period" and "patience." - JB

Riots in the Market

The old market line used to be "three steps and then a stumble." This implied the Fed would raise rates three times and then the markets would begin to feel the effects. Today, Greenspan needs to merely hint that maybe, possibly, some time in the future they are going to raise rates and the markets throw up.

Let's be clear about this. They are going to raise rates. The question is not if but when.

Bianco is right that if the data on jobs comes in strong in the next month or so and inflation is also on the rise, the Fed's hand may be forced.

But I am not so certain that data on jobs has been that strong, or that significant inflation is lurking around the corner. (To be sure, I see inflation in our future. The question is the timing.)

Let's quickly run down some statistics. First, last month's 308,000 jobs report was seen in many quarters as extremely positive. But looking at the underlying numbers, we find that 95% of those jobs were part-time or temporary jobs. My anecdotal observation is that this is a result of large numbers of people going off extended unemployment and they had to take a job anywhere to put food on the table.

The recent employment data reveals the actual number of unemployed went up and the unemployment number went up. Further, Richard Bernstein, Chief US Strategist for Merrill Lynch notes that "Real Wage Growth (Hourly earnings less CPI) has turned negative for the first time since 1995. If this continues, it would signify the first decrease in nine years of consumers' purchasing power. Portfolios are not structured for a decline in consumer purchasing power. Consumer Discretionary stocks remain the most over-weighted sector by most mutual funds. Although many observers have said that concerns regarding the health of the Consumer Discretionary sector are completely unwarranted, the "canaries" are indeed dying in the mineshaft. Despite a strong economy, mortgage foreclosures just hit a new all-time high!"

(As a quick aside, he shows data which suggests many mutual funds, in typical herding fashion, are heavily betting on consumer discretionary stocks, which make them vulnerable to a trend reversal. If you are buying a fund on recent past performance, which I always caution against, you are making yourself vulnerable as well to a trend reversal. Just a word to the wise.)

It is accepted wisdom in most quarters, including here, that rising interest rates will not be good for mortgages and thus housing, a key sector of the economy. But vulnerability in the housing sector may be worse than it has been in other periods when interest rates were rising. Let's look at this explosive analysis from one of my favorite sources, Greg Weldon of Weldon's Money Monitor. He has uncovered the following nuggets in the housing debate.

"Keeping in the SAME EXACT macro-vein, we rewind to examine the HUGE SUPPLY CAPACITY exhibited by the US Home Building industry, a juggernaut that is NOT going to 'stop' ... before ... demand has ALREADY rolled-over. In other words, arguing that the MBA mortgage data has PASSED a macropeak ... would mean that the Buildings and Permits data represents EXCESS 'supply capacity', such that COULD very well intensify downward PRICE pressure in this KEY, successfully reflated, wealth asset.

"Supply in the New Home market is SOARING. Worse yet, supply is EXPLODING at EVERY 'level', from Permits to Completions and then some. Note the details of the March Housing Starts data, and approach them with an 'output capacity' thought-process:

* Housing Starts ... up + 6.4% for the month, and EXPLODING at a +15.2% yr-yr pace.
* Single-Family Starts ... up 5.5% month, up +14.8% yr-yr
* Multi-Family Starts ... up +9.7% month, up +16.9% yr-yr
* Building Permits ... up +1.9% month ... up +15.3% yr-yr

"Dig these statistics from an output-capacity, excess supply, perspective:

* Completions of New Homes ... up +13.6% for the MONTH, now expanding at a +8.1% yr-yr rate.
* Homes Under Construction ... up +1.7% during March, and now expanding at rampant +16.7% yr-yr pace
* Homes Not Yet Started ... up a MASSIVE +4.8% for the MONTH, following a +2.8% rise in February ... for a near FIFTY percent annualized growth rate.

"Indeed, during the last two months ... SINCE rate started RISING, and since which time demand for Mortgages has fallen and may have peaked ... the Homes 'planned', but 'Not Yet Started have EXPLODED, to hit a fifty percent annualized rate of expansion !!!

"Worse yet, the UNDERLYING demand fundamental, as pertains to household income and wage growth, or more accurately, the LACK thereof, we rewind to note the April Philadelphia Fed Survey, which revealed the following:

* Average Work-Week ... 10.4 ... down from the 17.9 reading seen in March, and down from 23.6 in February.

"In other words, during the same two months that new homes supply that is planned, but not even yet 'started' ... the reading for the Philly Fed Work-Week index has been HALVED. Additionally, while admittedly miniscule in the net change, we do note that the Number of Employees Index has fallen for three straight months ... and, FAR MORE importantly, continues to FAIL to meet the heightened 'expectations' for employee numbers. We specifically observe this dynamic as evidenced within the highly optimistic 6-Month Outlook, which over the past six months has offered expected Number of Employee readings above 25.0. Alas, the 'Current Conditions' employment index has consistently registered readings at levels less than HALF what was expected, months ago, when optimism reigned."

(Greg's daily letter runs about $400 a month or so, and he does a special daily metals only letter which is less, but for my larger trader and hedge fund readers, I would suggest giving Bill O'Herron a call at 203-858-1459 and trying him out. FYI, I get nothing for this free promo, but simply really like Greg's work. And now back to our regular feature.)

Inflation? Well, Maybe

Last months CPI showed a 0.5% growth in inflation. The markets immediately seemed to multiply that by 12 and projected 6% inflation for the remainder of this year. First, year over year inflation is still well below two 2%. Secondly, much of the rise in inflation was from sources (like apparel) that are unlikely to be big sources for inflation in the future. Capacity Utilization in apparel is only 66%. The apparel industry, from a pricing power standpoint, has been in a slump since 1998. Yes, apparel prices have risen slightly over the last three months, but are still down over the last year.

Inflation is coming back, but its return is not going to be like switching on the lights.

Let's look at what the brilliant Richard Russell has to say about Greenspan's remarks this week before we wrap up this topic.

"Yesterday I noted that almost every sector of the markets that I look at is either toppy or weak. The markets, as I see them, are not saying that inflation has won the game, as per the Greenspan's view. Quite the opposite, I see the markets deflating -- almost all of them.

"I think the metals alone are telling the story. Gold down over five bucks this morning, silver down over 50 cents in the morning, This, Mr. Greenspan, isn't inflation, this is deflation.

"Here's what I think is happening. The debt is out there, tens of billions of debt, $32 trillions of total US debt. At the same time a huge segment of the US consumer population is holding that debt, much of this debt financed at ultra-low rates. Nobody has cash, everybody is thinking and acting as though its uninterrupted inflation as far as the eye can see. 'Everybody' is positioned for inflation, and here's Alan Greenspan hinting that the Fed's next move will be a boost in interest rates, and a boost that may be very close in time.

"Remember, the global forces of deflation continue to lurk in the background, and I'm talking about world overproduction accompanied by cut-rate wages out of China and India and much of Asia.

"Greenspan's words caught markets that were 'high as a kite' on the idea of inflation. When everybody thinks the same, nobody is thinking. When everybody is on the same side of the market, the 'same side' position becomes dangerous."

The Global Carry Trade

It is not just consumers and businesses that have lots of debt. I think one reason for the volatility of the markets is a clear sensitivity to a rise in interest rates which is the result of the fact that many of the investors and traders in these markets are leveraged, and some are highly leveraged.

Right now, in the trading world, the potential for profits from leverage is quite large, and thus leverage is high. It is known as the carry trade. Basically, if you can borrow money at 2% (or less!) and invest in funds or instruments which (you think) will pay 5-10%, then that is a seemingly good trade. Yes, you are subject to reversals, more volatility and a host of issues, but smart managers hedge for these events, or are simply willing to take the risk because they feel the reward is worth the risk. I admit to using leverage in some of my own investments. Now, here's the problem. At 2% cost of money, I deem the risk-reward ratio to be quite good. At 4% I may become cautious and somewhere north of there I simply take that particular trade off the table.

Indeed, the March IMF Report warned that "the steepness of the yield curve has encouraged the "carry trade" that has led to a huge build-up in long-dated leveraged positions financed with short term borrowings."

Managers throughout the world have the same problem. Whether they are slightly leveraged or heavily leveraged, they factor the cost of money into their risk tolerance. If you borrow short term money and you see rates beginning to rise, you are going to start talking "off" the trade. For many styles of investing, that cannot happen overnight or even within months. It takes lots of planning. If everyone heads for the exits at the same time, nobody will be able to get out.

They all know that, so there are a lot of "Nervous Nellies" in the investment world. They don't want to be the last to leave the dance. For some types of trades and investments a mere 1% rise in rates could significantly affect the profit potential. For others it might be 2 or 3%.

Thus Greenspan merely hinting that rates might be rising causes a significant rise in stomach acid on trading floors all over the world. Think what would happen if they actually raised rates in June and started to aggressively move up. The resulting action could be far worse than mere riots on Wall Street.

Greenspan and the Fed know this. Just as they jawboned rates down in 2002 and especially in the first half of 2003, they must now prepare the markets to gradually decrease its leverage. They need to first talk, probably change the language in the Fed releases, taking out the words which make traders think they have another 6 months and slowly, slowly, slowly push the carry trade off the table, de-levering the world. Watch in the next few months as Fed governor speeches start warning about a rise in rates. Last year they encouraged the carry trade. Now they will discourage it. And then they will actually start the interest rate increases. It will be well telegraphed. If it is not, it will create major chaos.

Jim is absolutely right in this. The neutral rate of the Fed Discount rate is in the 4% range, which would move 10 years up and push mortgage rates perhaps back to 8%. Remember, it was only a few years ago that two year rates were at 7%.

The economy is doing just fine but it is a good economy with a soft underbelly. Employment is still weaker than it should be and much of the current growth is from growing debt and stimulus. It would not take much in the way of rate hikes to hurt the economy via higher mortgages and higher interest rate payments for consumers. New auto sales and thus financing is highly sensitive to interest rates, as an example.

Bianco made the very important point last year that the Fed should have never used the words "considerable period" and "patience" because it would create problems when they finally decided to not have them in their statements. We are now at that time.

A sudden move, and June would be sudden in my book, would threaten the markets in the ways mentioned above. Once the Fed starts raising rates, they are likely to continue to raise them at every meeting until they get to that neutral rate. That means a series of 50 basis points raises for at least 4-5 meetings, or 25 basis points for 8-10. I believe the Fed will move more slowly in starting the process, giving traders plenty of warning and time to unwind trades and decrease leverage.

And they will start the process slowly. I do not think that two good employment reports are enough. They will need 3 or 4 at least. And as noted above, March's number which was 95% part-time and temporary was not exactly evidence of a strong and vibrant growing economy.

The conditions which would force the Fed to raise rates in June would be a dramatic rise in inflation. That is always a possibility, but I do not think a high probability one.

If this were not an election year, I doubt there would be any pressure to raise rates in June. The Fed could be patient and wait until August or September. But to do so means the Fed would be perceived as getting involved in the election process. Now, they have not been reluctant to raise or lower rates prior to an election in the past, and perhaps they still see themselves above the political fray. As Yogi Berra said, making predictions is very hard, especially about the future. And that goes double for predictions about the Fed.

I think the Fed will start to change their language and start to clearly let everyone know that they are going to start raising rates. I am not certain they think that a two month warning is enough time to allow the markets to adjust. For what its worth, I think it would take more than two months to unwind the massive carry trade we see today without causing some real market turbulence. Perhaps I am just an old worry wart, but I like these type of things to go nice and slow. Speed kills.

I do not think the Fed cares if gold makes new highs, or the dollar once again moves downward or the CRB moves above 300. They are more fixated on keeping the economy growing and employment rising. Long term rates will rise when they start raising short term rates, simply because the funds which have bought the long term bonds on leverage will start to sell them. If they push that market too fast, it could seriously back-fire, crushing the mortgage market and hurting housing values. Consumer sentiment (and thus consumer spending) is highly correlated with housing values.

I agree with Jim that rates should be higher. But the Fed painted themselves into a corner last year, and now they (and we!) have to live with that reality. Simply changing the language is going to create a big move in the bond markets.

Absent strong inflation and rapidly rising employment numbers, both of which I do not think we see in the next few months or so, I think they wait until at least August. I think the bet is still until after the election, but I must confess to looking over my shoulder on that prediction. If the facts change, I will change as well. We will need to monitor the data coming out over the next few months very closely.

But in any event, to the extent you have exposure to rising rates, whether as a trader, in your personal debt or mortgages or investments, I think it is time to begin to lighten up. Greenspan told us the train is going to leave the station. He just did not say when. I think it was J.P. Morgan who said something like, "I made all of my money by getting out too early."

We are getting ready to enter a period of potentially serious market volatility. Watching the markets the past few days gives me the feeling that things could break quickly.

Red-Faced in La Jolla

Next week I will talk about the problems with that traditional indicator of recessions, the inverted yield curve. I will discuss another predictor of recessions which Dennis Gartman has brought to my notice, which I think is worthy of your attention. By the way, it seems to suggest the economy is ok for the next 6 months at least, if not much longer.

I am writing today from La Jolla, where this Friday and Saturday I co-host my Strategic Investment Conference. Speaking with me will be Rob Arnott, George Gilder, Martin Barnes of Bank Credit Analyst, Scott Burns and Richard Russell. It should be a powerhouse conference. I will give you a full report in future issues of this letter.

On Tuesday I accidentally got some shampoo in my eye in the morning, and by the evening my eye was swelling and my face was turning red. The next morning my left eye was swollen shut, and I looked like I had been on the wrong end of a George Foreman fight. We are talking really ugly. I was scaring little children as I walked around. A trip to the emergency room at the Scripps Center and some steroids calmed things down. My face is still quite red and puffy, although now it just looks like a good sunburn rather than a walking rash.

And thanks to fellow plane passenger Steve Cook who knew the name of the band that sang the Song mentioned in the first paragraph. I have to confess, The Clash was not part of my youth.

I am back home Monday for a few weeks with no planes and the chance to watch a few ballgames from the office and see the Mavericks in the third play-off game. (I optimistically assume there will be one.)

Your having more fun than the law allows analyst,

Scroll down for comments.