Interest Rate Roundup

Tuesday, March 27, 2007

Inflation and interest rate concerns on the eve of Ben's big show

Tomorrow is the big day -- the day Fed Chairman Ben Bernanke goes before the Joint Economic Committee to discuss the economy. Heading into the session, there's a big debate about whether we're facing inflation, deflation, or stagflation. And frankly, what Ben says could have a major, major market impact.

Why do I say that? Look at the market setup going into this speech. Stocks have rallied back from the recent crack. I believe that's based on the assumption Ben will cave on inflation and signal that the housing problems are enough to prompt the Fed to back off ... or even cut interest rates. Measures of risk appetites, like emerging market bond spreads and carry trade currencies such as the Australian and New Zealand dollars, reflect that thinking as well.

The problem? Treasury bonds think Ben is full of it. They can't believe the Fed is even thinking about going dovish. Indeed, since the Fed ever-so-slightly moderated its anti-inflation rhetoric last week, long bonds have gotten shellacked and the yield curve has disinverted rapidly.

Me? I think Bernanke simply can NOT afford to take the wimpy way out. We keep hearing about how inflation is a lagging indicator, how it will come down with time, blah, blah, blah. But here we are nine months after the Fed stopped hiking and inflation is STILL not coming down. The year-over-year change in core CPI was 2.6% when the Fed stopped hiking in June 2006, and it's 2.7% now. There is NO evidence whatsoever that measured, core inflation is falling.

On top of that, MARKET-based, real-time indicators of inflation are rising fast. The 10-year TIPS spread is blowing out to the widest since September. And buried within today's consumer confidence report was news that expectations of future inflation are rising.

Here's one last thing to consider: If Bernanke comes out and signals that the Fed will try to "save" housing by cutting short-term interest rates, it might achieve the exact opposite effect. How? By causing long bonds to sell off and the yield curve to steepen even more. That would help drive UP rates on the very same longer-term loans (read: plain-vanilla, 30-year fixed rate mortgages) that are supposed to save consumers from unaffordable ARMs.

In other words, the Fed is in quite a box here. We'll have to see if it can find its way out.


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