Interest Rates

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Sally Limantour
February 20, 2007

We had a long weekend to digest Mr. Bernanke’s statements and his views on unemployment and inflation were telling. The Fed’s forecast for unemployment for the next two years is for the rate to remain between 4.5-4.75 per cent –right where it is. My interpretation is that he feels the economy is in a sweet spot and employment is good enough to keep the politicians at bay while foreign wage competition is dampening inflation potential of strong employment.

While Bernanke spoke of the downside risks of housing, he also said, “To the upside output may expand more quickly than expected.” This translates to mean that there is a chance for a stronger economy. Had he left this statement out, Treasury Bond Futures (US H7) may have closed the week closer to or above the 11200 level.

We have a slew of Fed speeches this week (this could restore rate hike fears) and CPI due out on Tuesday. While the Fed will focus on the core PCE Index, it is interesting to look at expected CPI as a general guide. The difference between the yield on a 10-year Treasury Note and the yield on an Inflation-Protected 10 year Treasury Note is basically the bond market’s forecast of the US CPI’s future rate of change. According to Ray Hanson, of the Speculative Investor, over the last 3.5 years expected CPI has been in a range of 2.25%-2.70%. “In other words, over the past 3.5 years there has been neither a deflation nor an inflation scare” hence, the Goldilocks economy and the strong stock market. Were we to break out of this range on the upside, rates would tighten and the stock market would suffer. On the downside deflationary concerns would spark interest rates to fall and commodity markets would be spooked. This brings me to the central banks and the current problems they face today in assessing “stability.”

Historically, central banks attempt to achieve stability by looking at changes in interest rates against measures of the amount of spare capacity within an economy. If interest rates can be moved to set demand at a level consistent with “supply potential”, then central banks will achieve stability.

Another more familiar approach is for central banks to monitor money supply growth in order to gauge inflation. These two models have worked well in the past but with globalization the central banks seem to be having a more difficult time measuring inflation and determining stability. In The Independent, 02/20/07, Stephen King wrote about the problems central banks are having with measuring the economy using an old paradigm in a world of increasing globalization.

The first approach has inherent problems in that countries dealing with large scale immigration are trying to figure out the size of supply potential. “The Bank of England, for example, has to fret about the scale of labour immigration. It knows the scale of recent immigration has been big, but beyond that, information is sketchy.”

The second problem is with measuring money supply. At the touch of a button and with the speed of light capital is flowing across borders while bank deposits are switching from one jurisdiction to the other making it difficult to know the “real” level of money supply. Perhaps this is one reason why the Fed stopped reporting M3? It may also explain why it has been difficult for traders to get a handle on interest rates – remember how bullish the market was towards a decrease in interest rates only to see them move higher? Market expectations have changed often over the last 12 months and the transparency the central banks are offering may in fact, be “revealing the uncertainties” they are confronting.

Readers in the Hamzei Analytics' Virtual Trading Room know I have been a seller of Treasury Bond Futures since Nov-Dec 2006– selling rallies and buying back on dips. After trading down to the low 110 area I have been flat looking to sell 11200 – 11208. In the big picture I believe we are in an upward multi-year trend in interest rates which will take years to develop.

Keep a heads up this week with regard to Fed speakers, Govenors Kohn, Bies, and regional Presidents Yellen and Fisher. Tuesday’s CPI number and the BOJ rate decision are also potential market movers. In addition, stay alert to more talk of a potential credit crunch precipitated by the housing downturn and rising default rates.