Interest Rate Roundup

Monday, June 16, 2008

Monday morning roundup

It's easy to stay in touch on the road, technology being what it is these days. But I still feel a bit discombobulated when I'm away from my desk for several days. So forgive me if this post meanders a bit -- there's a lot of stuff that I feel like commenting on ...

First, the newly-hawkish Federal Reserve may be having second thoughts, according to Robert Novak at the Washington Post. From a column that's up on the Post's website today ...

"Bernanke, according to sources, disagrees more with the European position than is reflected by his public statements. In his June 3 speech, he said that the jump in oil prices could simultaneously slow already low economic growth while raising inflationary dangers -- recalling the "stagflation" of 30 years ago. Privately, Bernanke is said to be much more concerned about low growth.

"According to these reports, Bernanke feels that oil at $125 a barrel and $4-a-gallon gasoline threaten contraction more than inflation, despite the daunting prices. The depressing impact on the oil-driven American economy is especially menacing in his view. Bernanke knows that he faces difficult choices that his lionized predecessor never had to confront. Indeed, the traditional tools of the central bank may be inadequate to the task.

"There is no question that the low-key Bernanke is calling the shots at the Fed. Lack of control by him was suggested June 5 when Jeffrey Lacker, president of the Richmond Fed, and Charles Plosser, chief of the Philadelphia Fed, in separate speeches took issue with the March bailout of Bear Stearns. But regional bank presidents play a minor role in setting monetary policy, and the other Federal Reserve governors go along with their chairman."

Second, the Saudis are pledging to raise oil output by another 200,000 barrels per day, beginning next month. That move would increase supply by just 0.2%. After briefly pulling back on the news, oil futures are spiking again (up by about $4). Why? I think it's this renewed "no tightening" talk. The Group of Eight nations also failed to call for a stronger dollar over the weekend. Both factors are causing the dollar to lose steam (it's down about 1.24 cents against the euro as I write).

Third, we continue to get economic data that underscores the stagflationary economic backdrop. The Empire Manufacturing Index, for instance, came in at -8.7 for June. That was down from -3.2 in May and below expectations for a reading of -2. The key "growth" subindex -- new orders -- fell to -5.5 from -0.5. But one "inflation" subindex (measuring prices paid) remained elevated (66.3 vs. 69.6 a month earlier), while another (measuring prices received) jumped to 26.7 from 15.2. That's the highest since January 2006 (27.4) and just below the all-time high (27.7 in January 2005).

Fourth, the list of executive casualties stemming from the credit crisis continues to lengthen. American International Group replaced its CEO Martin Sullivan with Robert Willumstad. AIG is the world's biggest insurer, and it has been losing billions of dollars in recent quarters as a result of the souring credit markets.

Fifth, real interest rates are deeply negative, and have been for the greater part of the past few years, if you use the federal funds rate and the year-over-year change in the CPI as your benchmarks. In fact, real rates are running at -2.2% (2% nominal FF rate - the 4.2% YOY change in CPI in May; See chart above). Bloomberg picks up the torch this morning, reporting that real 10-year Treasury Note rates have also been negative for the longest stretch of time since 1980. An excerpt:

"The bear market for U.S. government bonds that began three months ago is just getting started.

"For the longest period since 1980, U.S. inflation has been higher than what investors earn on 10-year notes, a sign that yields have further to rise. Treasuries paid 2.88 percentage points more than the consumer price index the past two decades, according to data compiled by Bloomberg. Investors who buy $10 million of the securities would lose $1.4 million over the next year if the relationship returns to normal.

"The math doesn't pencil real well,'' said Thomas Atteberry, a partner at Los Angeles-based First Pacific Advisors, who recommended selling 10-year notes when yields fell to a five-year low in March. He co-manages the $2 billion New Income Fund, which beat 96 percent of its peers in the past five years, according to data compiled by Bloomberg.

"The combination of rising commodity prices, Federal Reserve Chairman Ben S. Bernanke's renewed focus on inflation and his success in reviving capital markets after the collapse of subprime mortgages has turned Treasuries into a quagmire. Investors who bought notes due February 2018 on March 17, just after the Fed helped arrange the bailout of Bear Stearns Cos., have lost 6.2 percent, according to Bloomberg data."


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