Over the last couple weeks, so-called economic fundamentalists have been bellowing ever more stridently, if not angrily, that the bond market is nuts, totally ignoring strong April employment and retail sales data which have exposed the so-called soft patch in March data to be nothing but a mirage. There was no soft patch, they shout, while pounding their shoes in Khrushchev fashion on their desks: none, nada, zippo!

Thus, the notion that the Fed is about to stop tightening is utter nonsense, we are lectured. In turn, rallying bonds generating a bull flattening of the yield curve are not fundamentally "justified", we are told, and therefore, must be a function of so-called "technical" influences, as in supply-demand flows divorced from fundamentals. When these technical forces abate, we are warned, there will be a nasty fundamentally-driven bear market across the yield curve, as the market comes to accept that the Fed has a long tightening way to go before reaching a "neutral" real Fed funds rate.

As an economic fundamentalist, I understand this argument. There can, in fact, be disconnects between enduring macroeconomic fundamental influences and real time supply-demand forces. Indeed, there is a whole branch of economics devoted to this proposition: informational asymmetries between buyers and sellers, which beget the Market for Lemons (MFL) paradigm. Stay with me here; this is important, though admittedly a bit dense!

Figure 1 is a line graph showing the ISM U.S. manufacturing index and the fed funds rate from 1987 to 2005. The ISM Index, whose line is at the top of the graph, is scaled on the left, with the level of 50 marked with a horizontal line. During time periods when the ISM is below 50, the author observes how the fed funds rate has either dropped or remained steady, as shown in 10 shaded vertical regions on the graph. The fed funds rate has been rising of late, reaching 2.75% in March 2005, up from 1.0% in 2004. But the ISM Index in 2005 has been falling, to about 53, down from 62 in 2004, a high for the entire period. The recent decline of the ISM Index appears steep.

Lemons At A Premium?
As my colleague Mohamed El-Erian detailed yet again in this month’s Emerging Markets Watch 1 , the MFL thesis, which won Berkeley Professor George Akerlof the Nobel Prize for Economics, is intuitively obvious, as manifest in the used car market. Why does your new car depreciate 20-30% the moment you drive it off the lot? Very simple: potential secondary market buyers of your car presume that you know more about the car than they do, including whether or not it is a Lemon.

They don’t know that you know, of course, and in fact, your new car may well not be a Lemon; indeed, it probably isn’t. But potential buyers can’t know what you know or don’t know and, accordingly, must protect themselves by bidding 20-30% below what you just paid for the car in the primary market. Is this a "fundamental" or "technical" consideration?

I submit it is a fundamental exigency. Indeed, Mohamed’s objective to put up consistent alpha numbers is founded fundamentally on exploiting the MFL thesis: know your cars on a micro basis, thereby affording yourself the opportunity to exploit the market’s macro presumption of informational asymmetries!

Thus, it is entirely rational for Mohamed to speak of a "tug of war" between fundamentals and technicals in his sector, particularly with the advent of index products that open the sector to investing "tourists." These novice market players take long and short positions from a macro perspective, buying and selling baskets of bonds from emerging markets that they couldn’t locate on a map, and know even less about fundamentally.

So, if the MFL thesis holds for emerging markets, should it not hold for the pure duration market, either Treasuries or swaps? Implicitly, that’s what bellyaching fundamentalists have been arguing for the last couple weeks: they, the analysts, know something more about the future trajectory of the real Fed funds rate than do those putting their money on the line. Put differently, Treasuries are a Market for Lemons, but with a positive, rather than negative differential versus "fundamental" value (as is the case in used cars and emerging market debt) - borne of a safe haven motive.

I understand this argument. I do, I really do! Indeed, I argued precisely along these lines in July 2003, when declaring Treasuries to be in a "rational bubble". 2 Thus, I cannot reject cavalierly the line of argument espoused by wounded fundamentalist bears over the last couple weeks.

It’s a BW II World
I can, however, reject it non-cavalierly, on fundamental grounds. What consensus fundamentalists are missing is a fundamental structural implication of the prevailing Bretton Woods II (BW II) regime: a structural decline in the equilibrium level and term structure of real interest rates. This reality is a function of two key, fundamental drivers:

  • Downward pressure on U.S. wage growth from lower-priced non-U.S. labor, which effectively flattens the U.S. Phillips Curve, implying a reduced inflation impulse per unit of decline in the U.S. unemployment rate; and
  • High savings rates in booming emerging market countries, which are generating a glut of global savings and contributing to a deficiency of global aggregate demand.

These two forces, together, imply that the Federal Reserve - the center of the BW II universe, just as it was in BW I - must pursue a structurally kinder, gentler real Fed funds rate policy, so as to:

  • Generate robust aggregate demand growth in America, which is exported via the U.S. current account deficit to a demand-deficient world, and
  • Support lofty valuations and inflation in asset prices, in particular property, to provide a source of capital gains to supplement the income of American workers challenged by tepid wage gains.

Yes, it’s a perverse way to run a railroad or a global economy: America goes deeper and deeper into hock to the rest of the world while riding a wave of asset price speculation and inflation. Certainly not a fundamental textbook path to long-term prosperity! It is, however, precisely the fundamental textbook path to avoiding, or at least postponing, a short- to intermediate-term global spiral into a deflationary depression.

BW II, by linking mercantilist emerging market countries, notably China, into a de facto monetary union with the United States, represents a positive shock to global aggregate supply relative to global aggregate demand . Consequently, it is America’s global civic duty to live beyond its means. And it is the Federal Reserve’s global civic duty to facilitate American hedonism, because in the face of a positive structural shock to global aggregate supply, notably labor, American hedonism is not inflationary.

Accordingly, I submit that recent bullish action in the pure duration market is not technical churning in contradiction to economic fundaments, but rather rational market discounting of a structural change in global fundamentals, specifically, a secular downshifting in the "neutral" real short-term interest rate in the United States.

Revisiting the Alpha In Taylor
The ubiquitous Taylor Rule circulating in the noggins of most fundamentalists needs to be re-specified. Recall, the Taylor Rule is a prescription for how the FOMC should peg the Fed funds, usually specified as:

Fed Funds Rate = Equilibrium Real Short Rate + Actual Inflation + (a)(Actual Inflation - Target Inflation) + (b)(Actual GDP - Potential GDP)

For the sake of discussion, let’s assume that actual inflation equals targeted inflation (not a bad assumption right now!) and that actual GDP equals potential GDP (it’s actually a bit below, as there is still slack in the labor market). With those two assumptions, we put the economy theoretically in "equilibrium" - the exact sweet spot of its Phillips Curve. In which case, the last two terms in the Taylor Rule drop out, leaving:

Fed Funds Rate = Equilibrium Real Short Rate + Actual Inflation

When crafting his Rule over a decade ago, Professor Taylor assumed the Equilibrium Real Short Rate to be 2% and ever since, the economics profession, including economists that serve the FOMC, have systematically seen Professor Taylor’s 2% ante and usually upped him. They also declared that the Equilibrium Real Rate is "time-varying", meaning that it is a constant (technically, the alpha term in the Taylor Rule) that isn’t really a constant.

Thus, as long as the prevailing real Fed funds rate is below 2%, pundits - and the Fed itself! - uniformly and universally declare Fed policy to be "accommodative" rather than "neutral".

Which, of course, leads non-time varying fundamentalists to declare that it is plainly silly for anybody to buy duration in the face of "strong" economic data, which implies that the Fed will continue to march the real Fed funds rate to 2% or higher. Since such buying can’t be justified on "fundamentals", we are told, it must be the product of "technical" influences of a temporary nature, which will be reversed.

But if the Equilibrium Real Short Rate is only about 0.5%-1%, as Bill Gross and I have argued for the last two years 3, then we are presently very near equilibrium! In which case, the current term structure of both nominal and real rates (to wit, the bond market) is fundamentally justified with the prevailing 3% nominal Fed funds rate.

Put differently, maybe there isn’t a conundrum in low real long-term rates after all, as Chairman Greenspan intoned in February. Maybe, just maybe, low real long-term rates are simply the rational discounting of structurally low real short-term rates. Indeed, Fed Governor Kohn recently suggested precisely this possibility:

"…investors seem to expect short-term interest rates to remain on the low side of historical averages for some time. These subdued expectations may reflect a belief that underlying global demand will remain damped and that the world will continue to be willing to invest heavily in the United States."

Yea verily, I say: that’s what BW II is all about! Yet the Fed doesn’t really believe it. In fact, Governor Kohn was merely observing what investors "seem" to believe, rather than saying that he shares that belief. Accordingly, the FOMC is predisposed to continue hiking real short rates until incoming data tell them to stop - just as sour grape fundamentalists now argue.

I expect precisely such data in the weeks and months immediately ahead, despite "strong" employment and retail sales data released for April. What data, you say?

Just Another Napalm Sunset
The data is called the ISM Index (formerly the NAPM Index, colloquially known as the NAPALM Index). The ISM Index is the single best indicator of cyclical regularity in the manufacturing sector, itself driven by cyclically regular swings in the pace of inventory accumulation, which is the primary impulse to cyclical regularity in commodity prices (and the so-called PPI pipeline).

As the chart below screams, the U.S. economy is on the cusp of a swing from the sunny to the dark side of the inventory cycle: negative momentum in final sales growth faithfully leads the inventory sun.

Figure 2 is a line graph showing U.S. final sales to domestic purchasers and changes in U.S. inventories from 1987 to 2005. Final sales, scaled on the left-hand side and expressed as the 12-month change less the four-quarter moving average of the 12-month change, enters negative territory in late 2004, dipping to about negative 0.3% and ending up at around negative 0.2% in early 2005. Inventories, on the right-hand side of the graph, are expressed as the 12-month change in quarterly accumulation. The 12-month change drops in early 2004 to about $40 billion, down from about $80 billion. The recent negative momentum in sales growth opens up a gap between its line and the line for inventories above it. The graph indicates a two-quarter lead for final sales before inventories follow.

And as the other chart below screams, the ISM Index faithfully mirrors the inventory sun, going dark once the ISM Index prints below 50. At the moment, the Index stands 53.3, down from a peak of 62.8 in January 2004 (almost a year and one-half ago!).

Figure 3 is a line graph showing the ISM U.S. manufacturing index superimposed with U.S. inventories, from 1987 to 2005. Both metrics roughly track each other over the time period, and are trending downward in 2005. The ISM Index, scaled on the right-hand side of the graph, is in a steep decline since 2004, reaching 53 in 2005, down from about 63. Inventories, scaled on the left-hand side of the graph, are expressed as the 12-month change in quarterly accumulation. By early 2005, the 12-month change has dropped to about $25 billion, down from about $90 billion a year earlier.


Bottom Line
As the chart on the cover screams, the Fed, under Greenspan, has never kept tightening once the ISM Index drops below 50, as it is virtually certain to do in the months immediately ahead. Therefore, the market’s presumption (or assumption, in Governor Kohn’s lexicon) that short-term interest rates will "remain on the low side of historical averages for some time" will be validated by the data that traditionally drive Fed policy.

But there is one important difference this time: the prevailing real Fed funds rate will be lower - and I mean a lot lower! - than has traditionally been the case at the end of a tightening cycle. That’s called fundamental structural change, not simply irrational "technicals."

How will Greenspan signal his embrace of this structural change? Call it a hunch and only that, but he could do worse at his last semi-annual report to Congress in July than to simply repeat his famous Humphrey-Hawkins words of February 22, 1995, at the end of that nasty tightening sojourn:

"There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see signs that underlying forces are acting ultimately to reduce inflation pressures."

- Chairman Greenspan, February 22, 1995

It’s all the natural consequence of living in a BW II world!


Paul McCulley
Managing Director
May 19, 2005

1 " Revisiting the Market for Lemons", Emerging Markets Watch, May 2005
2 " Promiscuity In The Pursuit of Virtue", Fed Focus, July 10, 2003
3 "Is That All There Is - To A Fire?
", Investment Outlook, May/June 2003 and "Needed: Central Bankers With Far Away Eyes", Fed Focus, August


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This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.