A growing case for tightening

The proponents of a Fed rate cut point at the ongoing housing debacle, rising interest rates and commodity prices which they are argue are threatening to stifle consumer and business spending. On the other hand buoyant corporate profits, rising energy and food prices and strong global growth threatens to spillover in the form of higher inflation, warranting an eventual tightening of rates. Until recently, the bears had the upper hand, forecasting a fed rate cut before the end of the year but things have changed recently with the concerted global central bank effort to hike rates, indicating growing fears on inflation. Energy prices have been on an uptrend, coming within close range of last year’s records as a result of a combination of ever so stronger demand and tighter supplies. A catastrophic hurricane season over the summer is all it may take to push prices above last years record. Food prices have also been on an uptrend mainly as a result of growing demand for bio fuels. With U.S. legislation moving towards tighter environmental standards as a result of a combination of greater awareness of the issues at stake and the upcoming presidential elections, the move to alternative sources of energy will only exacerbate the short term pressure on food prices. As the correlation between headline and core inflation measures are relatively high (roughly 0.75 going back to the early 90’s) and as there tends to be a 6 month lag on average between the two measures, it is only a question of time before the jump in food and energy prices impact the core figures. As a result of this, the market is predicting a possible tightening by the fed no later than the first quarter of 2008.

The bears steal the show

Last week's interest rate jolt, reflecting a global expansion running at full steam seems to be overshadowed by the continued rise in crude oil prices (rapidly coming within range of last year's record level) and today's drop in housing starts, signalling that we may still have some way to go with the housing debacle. As mentioned earlier, rising interest rates (particularly at the real estate sensitive 10 year segment) is bound to exacerbate an already difficult condition. The corporate sector, which has seen a pickup of late is also likely to be hurt by higher rates.
So it seems that the bulls on the street, the one's that have been dismissing fed cuts for the year, may have been a bit premature with their assessments. It will take some time still before we get a clear picture, considering the multitude of competing factors swaying the economy in one direction or the other. What seems almost certain, however, is that the all important consumer is being battered on several fronts and, unless we see a radical change in this, the economy will undoubtedly suffer.

Yield curve under siege?

In the last couple of weeks we have witnessed a dramatic change in the shape of the U.S. yield curve which has shifted from being inverted to upward sloping. In previous cycles, an inverted yield curve was an almost perfect predictor of an impeding recession, but this time around, despite the slowdown in the U.S., a full blown recession is unlikely (although a fat tail event that would trigger the "great unwind" is not altogether impossible). Again, we can credit the paradigm shift for the shape of the yield curve, the recent sell off in the fixed income market reflects growing concerns on global growth and the rising risk of inflation. Normally, the yield curve should reflect the health of the local economy (especially in the U.S. which still commands the largest economy in the world), but instead what we are seeing here is a yield curve that is moving in sync with others so that it can remain competitive (not surprising considering that the U.S. is a net debtor nation and imports significantly more than it exports). The worry here is that if the yield curve continues rising, it could precipitate the slowdown by introducing further strains into the already battered housing market, make it more expensive for businesses to borrow and apply the breaks on the bustling LBO activity. With the amount of unquantifiable leverage circulating, a catastrophic "great unwind" could well be within reach.

Another perfect storm?

The surprise Kiwi tightening coming on the wake of the ECB rate hike triggered a sell off in fixed income markets as investors embraced themselves for the potential of additional hikes reflecting the strength in the global expansion and a rising risk for inflation. Markets were palpably nervous with the changing environment, leading to a jump in the volatility index (similar in impact to the Chinese triggered global stock market sell off at the end of February) and a drop in stock markets. Rising bond yields and a resulting shift in their relative attractiveness was another factor behind the sell off in equities. In the U.S., signs of a pick up in economic activity and better than expected trade balance figures were additional contributing factors that helped push the 10 year benchmark yield above the 5% psychological barrier. One clear impact of the rise in yields is it's corrosive effect on the yen and the Swiss franc resulting from the growing attractiveness of the carry trade.

Housing slump expected to drag on...

According to comments made by Bernanke, the sub prime debacle will continue to drag the economy for some time to come as a result of the "knee jerk" reaction of more restrictive lending policies for this segment. Indeed, there has been a strong drop in new construction and building permits lately. There is also a risk that this overflows into other segments. If we also take into consideration that the most recent core inflation figures remain above the 1 to 2% comfort zone, it effectively means that we will not be seeing any Fed interest rate action for a while, possibly not until early next year. One scenario (the most ideal one for the Fed) is that the slowdown is enough on its own to drag the core rate below 2% so that the Fed can shift from a tightening to a loosening bias and focus on employment. Apart from the housing market, capex and consumption are showing signs of weakness. On the other hand the weaker dollar and strong global expansion are factors that counter the drag on U.S. growth. The next few weeks and months should provide us with a better idea on which of the two counter forces end up dominating.