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April 8, 2005
In a thin-news week, long-term rates enjoyed a routine improvement from the quick run-up in March -- routine and temporary. The 10-year T-note's range: 4.62% last week, 4.40% yesterday, back to 4.51% today, taking mortgages from 6.25% to 5.875%, and back to 6.00% today.
The credit markets are in a standard, between-Fed-meeting pause, re-calculating how fast and how far the Fed will raise the overnight cost of money. It's certainly going to hike another .25% on May 3 to 3.00%, but the range of forecast from there is more scattered than at any time this year.
The high-rate voices insist that inflation pressure will force the Fed to switch from .25% hikes per meeting to one or more .50% moves, and to go at least to 4.50% by year end. Then, instead of pausing at "neutral", the Fed will adopt a tight policy. I assume that those with this forecast are short bonds, would profit handsomely from a sell panic, and are doing all that they can to induce one.
Low-side guessers expect a Fed pause any time, but they have already been wrong: PIMCO, the bond-fund giant, predicted a pause at 2.50%.
I think the centerline expectation is now a Fed at 3.75% by year-end, and trading the 5-year T-note strongly suggests a long pause there, or perhaps below. The 5-year hit 4.35% at the worst of last week, traded all the way down to 4.08% in this week's rally, and is settling at 4.15%. If the Fed is going past 3.75%, then the market would want a lot more than 4.15% from a 5-year note. If 3.75% is tops, followed by a pause, mortgages may not rise above 6.50% this year.
The economics governing all this Fed-guessing are as weird and circular as they can be. High oil prices should mean inflation, and a tight Fed. However, in an era of vast over-capacity in both manufacturing and labor, businesses can't raise prices and labor can't demand higher wages. This time, very high oil prices cut quickly into consumers' disposable income, rising costs eat into corporate earnings, and the global economy should slow, possibly with little actual increase in inflation. If that equation holds up, the Fed has only to remove the last accommodation left over from post-bubble ease, and the economy will achieve a soft landing.
The crazy part of this calculus: if oil prices suddenly retreat from what Mr. Greenspan this week called a "price frenzy", then the brakes will come off the global economy while residual inflation pressure from expensive energy is still in the system. In the worst case, accelerating growth and inflation (the bond bears correct by accident), the Fed would have to come hard and fast.
So the markets have been trading each day: oil above $57/bbl, rates fall and stocks sink. When oil falls, rates and stocks tend to rise.
The gaping hole in the theory behind the crazy part (the low-oil-high-growth-high-inflation-high-rate part): there is no way for oil to fall far except as a consequence of a global economic downturn that reduces demand for oil. Nothing in $55/bbl oil has unleashed new supply. $55/bbl ain't that high: in constant dollars it's only about half the cost of a barrel in the '79-'81 spike. Refineries are at capacity, worldwide, and new ones are not even on drawing boards. The Saudis say they're going to pump, but they are near capacity. Russia, Nigeria, and Venezuela are mismanaging themselves to reduced capacity.
The economic downturn that likely will reduce oil demand and limit inflation is underway. German unemployment is now 12%, the highest since WWII, and the rest of Europe expects only 1.5% GDP growth. Japan is re-entering recession and deflation, its exports shrinking. China is the great unknown, but any slowdown among the buyers of its exports can painfully expose its bubbled economy.
This situation calls for caution and gradualism at the Fed, and they know it.
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