Trust us, we're experts

While one might normally expect Thanksgiving week to be a relatively quiet one, nothing could be further from the case this year. Market participants may not be having a whole lot of fun (then agin, if they've been on the right side of some of these moves, maybe they have), but at the very least they've been kept on their toes. A month or so ago, there was an amusing email the wended its way around the world, with the punchline being that no matter what happens, the stock market goes up. Those days seem like ancient history now...

The big news overnight was the release of the minutes of the Fed's Halloween meeting, complete with an impressive annex detailing their economic forecasts. What immediately struck Macro Man was the relatively downbeat tone of the contemporaneous commentary. The text is replete with "yeah, but" qualifiers and references to downside risks. It's quite a stark contrast to the defiant comments coming from the recent speakers, which reinforces Macro Man's view that the hawkish remarks are an attempt to try and wean the market off of trying to dictate policy to the Fed.

If so, then the campaign ain't working; not only are markets pricing in a virtual certainty of an easing at next month's meeting, but sundry talking (or is that writing?) heads at Realmoney.com last night were calling for an immediate inter-meeting rate cut. Given that the S&P 500 is still up year-on-year, Macro Man does have some sympathy for the Fed in resisting the demands of beleaguered equity managers.

Less deserving of sympathy was the Fed's forecast profile, which included the proviso that all forecasts were based on the assumption of appropriate conduct of Fed monetary policy. These, then, are the outcomes that the Fed expects if and as it does the right thing. It's basically the Fed saying "trust us, we're experts." Righhhtttt.....

A couple of interesting nuggets can be gleaned from the forecast profile nonetheless. The first is that the Fed is relying on commodity prices to quit going up. The central tendency for core PCE over the next few years is centered on 1.75%, which more or less confirms that that, rather than 1.5%, is the Fed's implicit price target. However, the central tendency for headline PCE is only 0.1%-0.2% above core.

This despite the fact that the headline PCE deflator has, on average, been 0.5% higher than core over the past three years. Unsurprisingly, the year-on-year discrepancy between the headline and core measures can be explained by commodity prices. So in forecasting virtually no difference between headline and core PCE, the Fed is taking the view that commodity prices will flatline. In a world where demand growth for energy and food continues to outstrip supply growth, feel free to judge for yourself where the risks to the Fed's forecasts lie.
The relatively benign inflation forecasts are all the more remarkable given the apparent further downgrade to the Fed's estimate of trend GDP growth in the US. The chart below lays out the Fed's forecasts for real GDP growth and unemployment. What's interesting to see is that the mode in both 2009 and 2010 is around 2.5% real GDP growth with a flatlining unemployment rate. From this we can distill that the FOMC sees real growth of roughly 2.5% as around trend.

source: Federal Reserve
The implications of this observation are important. First, it represents a remarkable downshift in the estimate of trend growth in the US, from 3.5% in the late 90's to 3%-3.25% just a couple of years ago. It's even lower than the 2.75% or so that most observers have assumed for trend growth recently. What it means is that the Fed sees that inflation will be generated by a lower threshold of domestic growth in the future than has been the case in the past. Now, Macro Man's view here is that they may be overstating the case, and that inflation is a secular global phenomenon rather than a primarily domestically-driven one as was the case in the 80's and 90's.
Another outcome of this implication is that the Fed may be willing to tolerate somewhat lower troughs in growth in the future than has been the cae in the past, given that the estimate of the trend rate has been lowered. This could perhaps explain the hawkish rhetoric that has recently emanated from the FOMC. More importantly, the reduction in trend growth means that the Fed's margin for error has been reduced, that the buffer between trend growth and recession has declined. In other words, the cost of a policy mistake will be felt more immediately in the future than in the past. This suggests that "The Great Moderation" may have run its course and that we should expect both macroeconomic and financial market volatility to be secularly higher moving forwards.
So far, it appears that markets are unwilling to swallow the "trust us" line from the Fed. Equities have fallen sharply overnight, as have yen crosses. More literally, an erstwhile importer of Fed policy has once again loosened its ties to the US, as Kuwait has once again revalued the dinar against its reference basket today. Coming as it does amongst a flurry of comments from the GCC regarding currency policy, the timing couldn't be more significant. As the chart below illustrates, the KWD has now appreciated more than 5% against the greenback since the dollar peg was severed in the spring.
Whether the rest of the week proves to be a holiday, or merely a turkey, of course remains to be seen. But liqudity is atrocious and erstwhile favourites (FX carry, Hong Kong equities, the KRW) are getting ejected from portfolios. Per yesterday's post, fear is pretty clearly trumping greed at the moment, which may ultimately deliver some opportunities for tactical risk trades. However, we may have to let things go a bit further first. Trust me.....I'm an expert.
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6 comments

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Anonymous
admin
November 21, 2007 at 3:34 PM ×

Long equity and shorter Eu/$? Good luck. EU is whipping boy but which other currencies of large liquidity can be pushed up without massive intervention? Yen? Yuan? Not likely. What's the realistic alternative if you don't want a bunch of gold, Yen, or Swissies, or are overloaded already with same?

IMO high debt ratios nibbling at corp profits, apart from revenue slowdowns in many sectors in US. And elsewhere. And currencies are coming to a head of sorts. Euroland either slaps on tariffs, or the US, or both. Or CB's form a huge pool of funds to buy dollar to prop up same. Something is going to happen, sooner rather than later. Global re-coupling due to credit cycle changes may force collective thinking.

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Andrea (Florence, ITALY)
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November 22, 2007 at 8:20 AM ×

How about shorting EUR/NOK or even USD/NOK, instead? As far as I know Norges Bank is still in a tightening mode, despite the latest inflation reading. Norway's economy is booming, labor market is in tight conditions and the country is an oil exporter; NB is then expected to raise rates at least once by the end of the year or in 2008Q1. Don't you think that last weeks' move in the pair is a good example of market over-reactions and possible mispricings? Why are such currencies as NOK or SEK being sold the same way that high yielders ones are? Are they risky assets, just like carry traders beloved currencies (AUD, NZD or ZAR)?

Anyway, I think the greatest mispricing in the last forty years is that of England's football team...

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Macro Man
admin
November 22, 2007 at 10:30 AM ×

I am content to avoid the NOk for the time being. Sure, oil is near its highs, but the Norgesbank has recently dialled down its hawkish rhetoric. And the Nokky is frankly acting like an equity, and I am already worried about my long beta exposure there.

The England mispricing is a very localized one; only a certain cadre of domestics think the team is worth a damn. Resident neutrals (such as myself), those living abroad, and even honest Englishman know that they're mediocre at best. Still, the sturm und drang that surround the biennial failure does make me laugh...

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Anonymous
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November 22, 2007 at 6:51 PM ×

re: why are NOK and SEK being sold - downgrading of growth/inflation expectations, shift in sentiment toward believing the Scandi's won't be insulated from a slowdown in Europe, the UK, the US (...), and perhaps because positioning is crowded relative to the liquidity in those mkts. Long NOK (either vs. EUR or USD) has been a popular trade, based on what FX strategists send out, anyway.

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lv
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November 23, 2007 at 10:50 PM ×

I would like to suggest a different interpretation of the forecast section of the FED Minutes: Maybe is less of a forecast than a statement of intent. When those Bernanke & Bros . "forecast" very low growth+low inflation + increasing unemployment "assuming that the FED acts as needed to foster the dual-mandate" that sounds to me as an announcement of their intention of keeping their monetary policy relatively restrictive so those things come to pass. Actually, I suspect that the Fed "forecasts" imply a lot more of hawkishness than it is apparent at the surface, since due to the dual mandate, it is politically unfeasible for the FED to "predict"(i.e. to provoke) a recession and 1.5% to 2.0% is probably the lower bound of an acceptable GDP forecast. Just my two cents.

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Andrea (Florence, ITALY)
admin
November 30, 2007 at 9:04 AM ×

Ok, you were right... too much volatility in EUR/NOK, but after current week's spike up I'm all the more convinced that the pair is being overbought. I'll consider selling a call strike 8.3000, instead.

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