(Oct. 12, 2009 - Erwan Mahe) In the wake of Australia’s decision to hike interest rates on 5 October, many commentators around the globe applauded the move as a precursor of a shift to a normalisation of benchmark interest rates by the other G20 countries, starting with the United States, given the dollar’s (continued) role as the financing currency and US treasuries as investment instruments.
As such, when Fed board members reiterated their commitment to maintaining their institution’s credibility and Ben Bernanke commented that he would (obviously) tighten monetary policy when warranted by conditions, short-term interest rates climbed throughout the planet, hammering the prices of futures contracts in Eurodollars, Euribor (December 2010: – 20 cts), 2-year Tnotes and Schatz (+10 bp to 15 bp).
Some observers mistook the Fed’s decision to run Reverse Repo tests as the first sign of a tightening in monetary policy, but the Fed has been running these tests since March and several board members, including Mr Bullard, pointed out that they had nothing to do with the beginning of an exit strategy, but were simply a test! There are no real capital transactions in these tests!
So how do we make sense of the anticipations of high benchmark short-term interest rates and the continued fall in the dollar, gold trading at $1,055, oil climbing to $73.20 and the robustness of stock markets?
There is only one logical explanation, and it is not the hike in interest rates stemming from resurgence in inflation priced in by markets, with the curve flattening at not very tight long-term rates, but a hike in official rates triggered by the anticipated return of “growth”.
The flattening is very consistent with our interest-rate scenario, except that we are betting more on a bull flattening as opposed to bear flattening.
So does the Fed really want to hike interest rates, given that the FMOC says “interest rates will stay low for an extended period of time”, just confirmed by Mr Dudley (New York Fed) and Mr Bullard (St Louis Fed)? (texts in links)?
In order to respond to this question, which will be decisive for many asset allocation processes, I delved into the Fed’s own econometric models this weekend, which have changed significantly in recent years.
Everyone is now aware of the famous Taylor’s rule, which led to a huge controversy last summer between Taylor GS and the Fed.
However, the Fed does not follow this rule as we know it, since it prefers to use, for example, inflation forecasts more than past data to determine what should be the ideal level of Fed Funds, as noted by our Cypriot hero, Mr Orphanidès, pointed out in 2001.
One of the Fed’s specialists on this issue is Glenn Rudebusch, and his projections of the optimum rate do not at all point to a tightening before … 2012, at the earliest, as you can see in the graph, below.
Check out the study in its entirety.
The Fed's Monetary Policy Response to the Current Crisis
Source: Fed of San Francisco.
Two other points from this study published in May 2009 are worth noting:
- On the one hand, the unemployment rate, which was initially expected to peak at around 9.50% in 2010, is already at 9.80%, and is expected to rise further, which makes the optimal rate even more negative.
· On the other, the Core CPI, which has fallen to just +1.4% on an annual basis in August 2009, should increase again in Q3 2010, according to these projections (which would thus leave the optimal rate at à -5%).
However, the most important component of the CPI, representing 40% (!) of the core index, is Owner Equivalent Rent, and this figure will be heavily affected by the US stimulus plan with its $8,000 tax break for first-time home buyers.
While this measure helped stabilise part of the real estate market, since it relates to 40% of all home buyers this year, it is also pushing down the property rental market, as renters move out, pushing up vacancy rates to record highs (see graph, below)!
Not only is that bad news for the apartment CMBSs and, thus, banks exposed to this securitisation segment (mainly medium-sized regional banks) but, above all, the higher the vacancy rates, the more rents decline and the OER with them!
As such, the Core CPI should not rebound, as indicated in the Fed’s graph N°1 for 2010. On the contrary, if this movement in rents is confirmed, it could even fall into negative territory, which implies that the ideal Fed rate will not move towards …-2.5% of graph N°2, and that the quantitative easing policy, which is the only want to fight against “zero barrier, will be around for some time to come!
I know I must be the only person on planet earth to factor in the possibility of a prolongation of this QE, but we shall see.
US rental vacancy rate
Source : calculatedriskblog
In other news, wholesale prices in Germany, out this morning, turned out to be worse than expected at -0.2% in September (-8.1% y-o-y) vs expectations of +0.3% for the month (-7.7% y-o-y). In fact, following the 10% plunge in H2 2008, these prices have been stuck at June 2007 levels.
Just to touch on one of my favourite themes: CDS’s contribution to debt deflation.
This phenomenon was illustrated again with the renegotiation of Thomson’s debt (for the curious, check out the following link). In short, this case shows once again that during bond debt negotiations, holders of CDSs have less and less reason to be conciliatory as it make more sense for them to let the firm go bottom up.
No change in our investment focus:
· positive bias toward government debt instruments, especially, on the eurozone 5-10 year segment, which benefits from the ECB's credibility;
· we prefer limiting hedging operations to small deltas, to theta and to minimum credit.
(With each market rebound, we can see the might of end buyers, who feel suffocated by 0% interest rates, and who will therefore continue to prop up stock indices for a while longer whenever they shows signs of weakness).