I don’t have a dog, but rather a rabbit, the lovely Morgan le Fay. I submit she knows more macroeconomics than most macroeconomists, as her public dialogues with me attest. 1 I adore her and thank the many dear readers who email me all the time, asking "after her" (in the jargon of my youth, growing up in the south). She’s doing just grand, even north of eight years old, which is a two-standard deviation journey in longevity for bunnies.

Her eyesight ain’t what it used to be and she can’t handle whole carrots anymore, needing those shredded ones that come in a baggy. But she’s more cuddly than ever, even welcoming toddlers joining her in her fenced playground out on our dock, gamely letting them beat her about the ears with their tiny hands, all in the spirit of trying to pet her.

And just yesterday, when friends with two little dogs dropped over to watch July 4th fireworks, Morgan actually smooched one of the dogs - who, while small, was still about three times her size! - who stuck his nose between the rails of her playground fence. It was the proverbial Kodak moment, except for the fact that our Olympus digital was actually in the kitchen recharging. That’s technology for you!

But it did get me to thinking about maybe, just maybe, getting a dog. In my 48 years, I’ve never had one, and I’ve been warming for years to get one. But with Morgan being a rabbit and dogs liking to chase (eat?!?!) rabbits, I’ve never seriously considered it, thinking that a dog would have to await Morgan’s eventual journey into the good night, hopefully many, many standard deviations in the future. But now, I’m thinking maybe, just maybe, a dog could have a place in our home, along with Ms. Morgan.

For, you see, a dog would bring something to my life that Morgan can’t: a walking companion. And the older I get, the more I enjoy a good walk (which my doctor also says is good for me). Beyond that, I have observed that dogs like to just hang out with their owners, offering unconditional affection, whereas rabbits are quite conditional in their love. Yes, even Morgan, who will, even with me, summarily reject lettuce of insufficient freshness by stacking it up, leaf by leaf, in her potty box (yes, she is trained!).

Her doing so doesn’t really bother me, with one huge exception: it reminds me too much, way too much, of the bond market when it gets data that it thinks the Fed will view unkindly, stoking its tightening proclivities. And when I’m trying to get away from work, I really don’t need such vivid reminders of the macabre logic of my life’s chosen profession. I need an oasis of something completely different. Yes, perhaps I need a dog!

The Bond Market’s Dog: ISM
While bond market participants live in fear of the Fed, given that the Fed owns a printing press for money and we don’t, we actually have an unconditional friend named the ISM (Institute for Supply Management) Index. Formerly known as the NAPM (National Association of Purchasing Management) Index, the ISM Index is the single best statistical indicator of the direction and pace of manufacturing activity in America, which is the single best cyclical indicator of the direction and pace of Fed policy.

The figure shows two line graphs covering the time period 1987 to 2006. The first graph includes two metrics: the 12-month change in U.S. inventories, scaled on the left, and the ISM index of U.S. manufacturing, scaled on the right. Both metrics roughly track each other over time, and are at about the same spot in 2005, with the 12-month inventory change at about $30 billion and the ISM Index around 52. Both metrics have been moving downwards since around 2004. A second chart below shows the fed funds rate, which is increasing in recent years, to 3.25% as of 30 June 2005, up from about 1.5% in 2004. The chart though shows how the rate has trended downward over time, from a high of about 10% in 1989. 

Yes, Virginia, the business cycle is, in the end, all about manufacturing, even though manufacturing represents an ever-smaller share of GDP. There is a simple reason for this: manufacturing is where the sun rises and sets on the inventory cycle. And the inventory cycle is what the business cycle is all about: the never-ending dance between customers’ orders and producers’ ability to meet those orders. A surprise on orders, positive or negative, has long ripple effects, exposing either too much or too little inventory and either too aggressive or not aggressive enough pricing.

Such is the stuff of business cycle life, with the Fed right in the middle of it, as the Fed has the power - that printing press, remember! - to both induce surprises in orders and to punish surprises in orders that it doesn’t like. In many respects, the Fed is similar to a bartender in this regard, with the ability to trigger chain reactions in a saloon by toying with the timing and terms of happy hour prices.

For the Fed, changes in the real Fed funds rate are the operating instrument: tightening when the sun is rising on the inventory cycle and easing when the sun is setting. It really is that simple!

You don’t have to take my word for it. As Yogi Berra says, "you can look it up:" it’s the cover graph! There is noise on the straightaways, as you can observe. But in the tight corners, also known as cyclical inflection points, the prescience of the ISM in "calling" the inventory cycle and with a lag, the Fed cycle, is clear. "Crystal," as Jack Nicholson says.

Bonds don’t wait for the Fed, but rather take their cue from the ISM Index. Indeed, to demonstrate the power of ISM Index as a candidate to manage your bond portfolio, I did some simple simulations with our financial engineers here at PIMCO (I really enjoy working with them, a perfect case of exploiting both absolute and comparative advantage!).

Our test: Let’s make the ISM Index an active portfolio manager and give her only one tool: go one year long of duration at cyclical ISM peaks and go one year short of duration at cyclical ISM troughs, implemented in ten-year swaps, rolling the position every month. For this exercise, it really doesn’t matter what her benchmark may be; remember, benchmark performance - beta - can be had for virtually free; alpha is what active managers are paid to generate and alpha can be "ported" to virtually any benchmark. 2

The results? Quite sweet! Here they are, since 1991:

But, you counter, rightfully, that our hypothetical, median-beating portfolio manager couldn’t have known the ultimate peaks and troughs at the time they printed, but only with "confirming data." We thought of that and ran two more simulations: a one month lag before our manager bought or sold her one year of duration and two-month lag. Here are those results:

As you can see, it didn’t cost very much at all to wait a month for the "confirming data" before implementing the duration reversals, but it did cost a fair amount to wait for two months. I’ve intuitively known this, but it’s good to see the empirical results support the intuition. Cyclical turning points in ISM are powerful! You can cheaply nap for a month, but snoozing for two months will cost you dearly.

The ISM Dog Says the Conundrum Dog Don’t Hunt
While everybody and his unemployed brother-in-law is talking about Greenspan’s infamous conundrum, focusing on falling long rates since the Fed started hiking short rates on June 30, 2004, our friendly ISM dog sees no conundrum at all, given that the ISM Index peaked six months before the Fed started tightening! What our pooch observes is that long rates had risen sharply the year before the Fed started tightening, mirroring the ISM Index’s steady climb from 50.4 in June 2003 to 61.2 in June 2004. More precisely, the ten-year Treasury yield troughed at 3.1% on June 13, 2003, rising sharply to 4.9% on June 14, 2004.

The figure is a line graph showing the nominal ISM U.S. manufacturing index superimposed with the year-over-year basis point change of the 10-year U.S. Treasury note, from 1983 to 2005. The metrics roughly track each other over time. In 2005, the nominal ISM is about 53, while the year-over-year change in the 10-year yield is about negative 100 basis points. Both metrics are near the middle of their ranges over the time period.  

As I see it, the fact that long rates have declined since the Fed started tightening is simply proof of my long held doctrine that bonds need not go to hell twice for the same strong-growth sin. This was particularly the case in this cycle, given that the Fed implemented a regime change in its policy arsenal in August 2003, introducing the forward-looking (conditional) precommitment strategy, initially with its vow to remain accommodative for a "considerable period."

The fact of the matter is that there is no conundrum in what long rates have done since the Fed started tightening, if you look at what both the ISM Index and long rates did in the year before the Fed started tightening! That no-conundrum case is even stronger when looking at a nifty knock-off of the ISM Index created by my good pal David Rosenberg at Merrill, who transformed it from a real indicator to a nominal indicator.

For those who don’t know (no need to send me a confessional email if you don’t!), the oft-cited ISM Price Index is not part of the aggregate ISM Index. What David did was simply add the ISM Index and the ISM Price Index and divided by two, to create what he calls a Nominal ISM Index. And as you can see in the graph above, it tracks beautifully with the nominal ten-year Treasury yield, capturing the huge increase in long-term yields in the year before the Fed started tightening a year ago, as well as the decline in long-term yields since the Fed started tightening.

There is no conundrum! The ISM dog hunts, with even greater predatory proclivities when sleeping in David’s nominal kennel.

Bottom Line
Thinking more on it, perhaps I shouldn’t get a dog, because it would be hard for me to resist naming him (or her) "ISM," which would be a cruel thing to do, particularly since Morgan le Fay has such an elegant name. ISM belongs at the office, I must conclude, where it provides bountiful love with its alpha-generating powers. The manufacturing sector is the straw that stirs the business cycle drink, and ISM is a great bartender.

Who is saying right now that, notwithstanding the "surprise" pop in the ISM Index to 53.8 in June from 51.4 in May, the Fed’s current tightening cycle has about run its course. That’s the good news the bond market has been discounting all year long, in the face of conundrum-singing naysayers.

That’s also the bad news. The bond market won’t get to go to total return heaven twice for the same falling ISM Index good deed, just like the bond market didn’t have to go to hell twice for the same strong-growth sin.

We’re not quite all the way to heaven yet, as the ISM Index hasn’t completed its cyclical journey to below 50, although David’s Nominal ISM Index is awfully close, with the Price Index falling points last month to 50.5 from 58.0 in May, dominating the 2½ point increase in June in the ISM Index itself. Thus, the ISM dog still has some bull hunt in him, implying that it is not yet time to cyclically go way short duration. That time will be when the bond market starts romancing not just an end to Fed tightening, but the beginning of a Fed easing process.

Some of us in the market are starting to talk about that scenario in public, notably my partner Bill. But the consensus is still questioning our sanity and the term structure of rates certainly isn’t discounting a turn to easing (as it is in the UK and Euroland).

When those two things change, it will be time to sell.

Paul McCulley
Managing Director
July 11, 2005

1 "Confessions of Optimistic Principled Populists", Fed Focus, December 2004, /LeftNav/Late+Breaking+Commentary/FF/2004/FF_December_2004.htm

"Isle of the Pears", Fed Focus, January 2004

2 I am making some simplifying assumptions here, which are really not so simple. For a full and excellent discussion of the nuances of beta management, see "Alpha/Beta: Separation, Transportation, and Recombination," available on www.pimco.com at the following link: /LeftNav/Latest+Publications/2005/Alpha+Beta.htm.


Past performance is no guarantee of future results. 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.

Each sector of the bond market entails risk. The guarantee on Treasuries is to the timely repayment of principal and interest, shares of a portfolio that invest in them are not guaranteed. Duration is a measure of price sensitivity to interest rates and is expressed in years.

The simulated portfolio example is a hypothetical illustration for educational purposes only. It does not represent actual results of any portfolio or particular investment. The selection of a different proxy for this illustration could produce different results. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

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