July 2008

Elephant Talk

Talk, It’s Only Talk…We’re sure you’ll fully remember the old adage, “watch what is done, not what is said”.  Well, it’s time to trot it out one more time as being very important to our current circumstances.  Why?  As you know, over close to the past month or so our favorite merry pranksters at the Fed have been running around thumping their collective chests and talking tough about inflation.  Believe us, we really have to try hard to contain personal outbursts of laughter when hearing these comments.  Not only is this type of dialogue and message about as disingenuous as the day is long, this tough talk is coming from the folks that make up the very institution responsible for the ravages of monetary inflation and domestic currency devaluation in the first place in the US. 

How folks can believe what this crew has to say about being vigilant about inflation is beyond us, but what is important is not the ranting and raving about the Fed, but rather investor behavior and actions in response to recent commentary from the FOMC members about their intent to focus on inflation.  As you know, post Bernanke and Geithner jawboning about their newly found inflation fighting fervor (no problem, it only took a 700% increase in the price of crude to get their attention decade to date), consensus talk has revved up regarding the outlook for Fed Funds rate increases prior to year end.  The Fed Funds futures market has already been pricing in the chances for a higher Fed Funds rate prior to year-end for some time now.  About a 30% probability as of late.  But post the recent comments, the Fed Funds futures market moved toward pricing in a 75bp rise over the forward nine-month period.  Likewise post these tough boy comments, gold got smacked around a bit and the dollar caught a bid or two, although both of these short term movements are already in the throws of change.

Let’s get to the point at hand.  As we look back over historical experience, there are many relationships between macro economic statistics/anecdotes and the Funds rate that have stood the test of time.  Unless we are about to rewrite history in our current circumstances, these relationships strongly suggest that there is no way the Fed is about to raise the Fed Funds rate any time soon.  We want to show you a number of anecdotes that speak directly to our little supposition.  And why is this important?  It’s clear as per the action in the Fed Funds futures market as of late that the Fed has in part actually been shaping investor perceptions and expectations with its recent commentary.  As we look ahead, if indeed global inflationary pressures continue to express themselves AND the Fed does not act, as its recent comments suggest it will, then we believe financial markets will move to reprice financial assets that have responded in recent weeks to the Fed get tough on inflation proclamations.  Assets such as the US dollar, gold, and a good number of global commodities whose primary trading unit is the dollar.    

Let’s start with a little look back at a number of key domestic economic indicators.  First at bat is the US labor market, specifically the unemployment rate.  Remember that with the recent May payroll employment report, the unemployment rate spiked up from the 5% level to 5.5%.  That caught the attention of the greater investment crowd when reported.  Right to the point, message being, at least over the last half century NEVER has the Fed been tightening interest rates while the headline unemployment rate was accelerating higher in meaningful fashion.  NEVER.  Have a look at the following chart. 
          

You can see exactly what we are talking about as you look at the blue bars that represent historical periods where the US unemployment rate has been heading higher in each cycle.  There is one minor aberration here and that is the late 1970’s through 1982 period.  In every bar we inserted, we tracked unemployment from the cycle low to the cycle high except for the cycle begun in the late 1970's.  During that period, interest rates were indeed moving higher while unemployment began to creep up for the cycle.  It’s when the unemployment rate really accelerated higher in the early 1980’s that the Fed Funds rate was falling meaningfully.  You know and we know this was quite the special time in modern US financial market and economic history in that the Volcker Fed applied inflation expectations shock treatment to the system by raising the Funds rate to a level that was considered unthinkable prior to its occurrence.  Outside of that, in every other period of unemployment rate cycle trough to peak, the Fed was easing.  Every other time.

Okay, now that you already know the punch line, our wonderful observation is that there is absolutely no way the Fed is going to start increasing the Fed Funds rate in the current cycle until they are well assured that US labor markets have stopped deteriorating.  NO WAY!!  And that means the unemployment rate is going to need to peak first.  Let's face it, the unemployment rate has just started to spike higher with the May payroll report.  We're just getting warmed up.  This is simply emphasized if we conjoin current labor market conditions with what is occurring in the financial sector/credit cycle.  The Fed can jawbone all they want, but we need to watch their actions and tune out the sound bites entirely.  No rate hikes any time soon, that's our take on life, based on labor markets and unemployment trends specifically.  As a little bit of an exclamation point behind this line of thinking, we’ve put together a short table to help give us some perspective, help guide our actions and point us to potential opportunities ahead.  It's the prior half-century history of peaks in the unemployment rate alongside the subsequent beginning of follow on monetary tightening cycles.  Have a look:

As you can see, literally the shortest period from unemployment cycle highs to subsequent initial Fed tightening actions is three months (1970-71).  The longest period?  Two years, following the very meaningful and deep recession of the mid-1970's.  This little message of history tells us that the earliest we might be able to expect a monetary tightening is in maybe September of this year, IF the unemployment rate peaks right now and begins to subside meaningfully.  How likely is that to happen.  How does the chance of lightening striking sound?  History also tells us something else as we look at the chart of unemployment.  The smallest increase in the unemployment rate from cycle trough to peak over the period shown was in very round numbers 2%.  We're maybe up 1% from the bottom of the current cycle, implying at best a 6.5% unemployment rate peak before the current cycle has concluded if indeed this unemployment cycle is simply to be very modest in nature.  To be honest, we'd be a bit surprised if it ended there given the very meaningful credit cycle issues of the moment that will undoubtedly have a profound influence on the real economy, as is indeed the case right now.

Another key economic indicator telling us a Fed tightening is as of now nowhere on the horizon is the consumer confidence measure.  We’ll move through this quickly as you clearly get the larger conceptual thinking after reviewing the relationship between unemployment and the Fed Funds rate above.  Right to the chart of historical experience.
        

This time around we’ve shaded in blue bars the periods where the Funds rate was being increased for each cycle.  Again, we view the late 1970’s/early 1980’s as a good bit of an aberration relative to the breadth of historical experience.  Once again, NEVER has the Fed been raising the Funds rate prior to a definitive bottom in consumer confidence.  For every blue bar depicted above, we’ll document to you in the following table the time distance between the interim bottom in the confidence index and the subsequent beginning of the follow on monetary tightening cycle.         

We currently rest at a headline consumer confidence number not seen since the early 1990's.  Have we hit bottom yet?  We have no way of knowing.  The table above covering the last quarter century tells us that the earliest the Fed has begun to raise rates after a consumer confidence cycle bottom has been nine months.  You get the picture, as per the historical message of the interplay between consumer confidence and the Funds rate, we're nowhere close to a rate hike at the moment.

Although we could clearly go on for pages regarding the greater messages of history, we'll leave you with one last anecdote we believe is important.  And that's the relationship between the Funds rate and small business confidence.  You may be familiar with the NFIB (National Federation of Independent Business) as they are the largest US small business trade organization.  And small businesses are the largest domestic economy employer group.  The historical relationship between the NFIB optimism survey index and the Fed Funds rate lies below.
       

First, the headline optimism survey hit a level in the June report not seen literally since 1980.  Very much in line with what we are seeing in headline consumer confidence surveys.  And you know that at that time, the US was embarking on one of the deepest consumer driven double dip recessions of the last half-century at least.  Inflation at the time was running rampant and the Volcker Fed was in the midst of jacking up interest rates to what was considered the stratosphere during that period.  Today, those peak interest rate levels in the high teens would surely be considered unimaginable.  Yet business optimism of the moment is now as low as that dark economic period of the early 1980's.  In our minds, this is a message from the small business community not to be taken lightly in terms of its ramifications for the immediate forward character of the domestic real economy.  In terms of importance to our investment activities of the moment, it further reinforces our thinking regarding the need to clearly bifurcate investment opportunities that relate to the global economy as opposed to the domestic only economy. 

At least according to the playbook of historical experience, small business optimism has tended to bottom and turn up during monetary easing cycles.  And usually not too far after a monetary easing cycle has begun.  Yes, there has been some chopping up and down in optimism as monetary easing cycles have begun in the past, but the issue is that small businesses have indeed responded positively to monetary easing with an ultimate upward bias in optimism as the easing cycle has run its course.  Looking back over the last two plus decades, we've shaded in these periods of major monetary easing cycles where it is clear small business optimism has bottomed and improved.  Of course the punch line of the moment is that in the current monetary easing episode, there has yet been no bottom in small business optimism at all, despite both a very meaningful cut in the Funds rate and the fact that we are ten months into the monetary easing process.  This is uncharacteristic.  This is an anomaly relative to historical experience.  And, again, given the importance of small business as really being the backbone of the domestic economy, not to be taken lightly.

The second reason we included the Fed Funds history alongside the longer-term small business optimism numbers is simply to reinforce the message of this discussion.  As is clear above, at least over the last two major monetary easing cycles, the Fed did not begin to increase the funds rate until well after the small business optimism survey had bottomed and already begun to turn back up.  This is yet again another data point telling us there is no way the Fed is about to start raising interest rates, despite the lip flapping as of late.  A tightening of monetary conditions simply is not going to happen until small businesses begin to feel better about life, and first they have to stop feeling pretty darn bad as per the data of the moment.

Babble, Burble, Banter, Bicker Bicker Bicker, Brouhaha, Balderdash, Ballyhoo - Its Only Talk...So there you have it.  Despite the tough talk and the guessing as to when the Fed will raise rates, our thinking is that a monetary tightening cycle isn't even close.  Not a chance.  We've got a long way to go before the Fed will act on what they are saying regarding inflation at present.  Sure, it sounds good.  Sure, in part it has to be a reaction to the genuine inflation focus of folks like the ECB and the central bankers in Australia.  But in our minds, there will be no bite behind the supposed Fed bark any time soon.  The Fed Funds futures market is jumping the gun.  If indeed we are correct in our thoughts, then before long the financial markets themselves will come to realize the Fed bluff.  Again, the reason we believe this discussion is topical is that as we see the financial and commodity oriented markets respond to Fed commentary, we can hopefully take advantage of near term price aberrations set against what history has to teach us about factual reality.  Who knows, that may mean circumstances for gold look a good bit better, especially if tough Fed talk is followed by inaction, which we are pretty darn certain of, essentially further undermining their credibility as supposed "inflation fighters".  If indeed the US dollar has rallied based on the belief that the Fed will indeed back up their inflation fighting comments with near term action, then that belief is incorrect.  We're sure you get the point.  In all sincerity, we do not mean to be wildly critical of the Fed.  In reality, they have our sympathy in the current cycle.  As we have hammered home as a major investment theme decade to date, globalization changes everything.  In a globalized world characterized by heightened importance of inter market capital flows and inflationary price pressures increasingly being set by supply and demand dynamics in foreign economies at the margin, the US Fed finds themselves in a marginalized position of monetary policy authority with a greatly diminished capacity to influence forward outcomes.  It's when the financial markets believe otherwise that opportunity is created.