A wiser man would stay silent and let the freshly chastened New York Times – ex Judith Miller – or a growing number of mainstream publications carry the load. People resent moneyed financiers such as George Soros reinventing themselves as public policy experts and this Outlook may be interpreted as such. But I am no expert, just a bond manager with a blog who has earned the privilege of readership concerning bonds over the past 30 years, and who sometimes speaks his mind on other matters. Management at PIMCO and some of you clients won’t necessarily agree with me. PIMCO doesn’t have a foreign policy view. I do. My views represent the politics of an ordinary American citizen with Republican roots, devoid of top secret or inside information – a Will Rogers policy: all I know is what I read in the newspapers. Still as the Doobie Brothers once sang, “I ain’t blind and I don’t like what I think I see.” They took their song to the streets. I’m takin’ it to the blog.
I find it interesting that nearly every second-term presidency in modern history has its scandal, with recent ones accompanied by the infamous special prosecutor. The hubris of power may in part be responsible but the opposition’s patterned response is really a result of our democratic process mandating a fixed four-year term. Unable to bring the current government down and dissolve Parliament/Congress and the Executive Branch when things go wrong, as is the case in Europe, we appoint special prosecutors to neuter an out of favor administration for the next 2 or 3 years until redress can take place at the polls. Clinton was neutered and even impeached. Reagan was neutered via Iran Contra. Nixon was expelled. Now Bush Junior’s number is being called.
The reason that W is on the hot seat of course has nothing to do with whether Karl Rove or Scooter Libby “outed” CIA agent Valerie Plame, and everything to do with the Iraq War, and perhaps even a growing dissatisfaction with America’s course in general – our changing perception as the world’s leader as well as the unbalanced distribution of wealth within our own borders. The war, Katrina, gas prices, and Republicans’ continuing focus on tax cuts as the elixir to cure everything are getting ordinary citizens downright depressed. “Plame-gate” is the result. Their dissatisfaction’s focal point is the war: the pretenses under which it was initiated, the lack of visible progress despite the recent approval of an Iraqi constitution, and the absence of a timeline for an exit of U.S. troops.
My position on Iraq was well publicized before the war and doesn’t require repeating here. In the 2+ years since I last wrote, much has come to the public’s attention and it is obvious at least to me that there is blame aplenty, including not only the President and his advisors, but an uncritical Congress and the press, conservative and liberal alike. But it doesn’t change things now that we didn’t discover weapons of mass destruction (WMD). What that realization should change, however, is how we approach the future – hopefully with greater scrutiny from all parties including the public, which just sort of trusted its elected first and second estates and assumed that the fourth estate was doing its job. What America needs now are more reporters like Frank Rich and fewer Judith Millers; more politicians like former Governor Howard Dean and fewer like the “go along to get along” John Kerry. I think we should also be looking for the first authentic presidential candidate – Republican or Democrat – to stand up and recommend a future course of action that offers Americans a choice at the polls beginning in 2006. We deserve a leader with the willingness to at least address the possibility of a policy change in Iraq , and who is willing to risk disapproval from a vocal minority or even a silent majority to lead his or her party and this great country of ours towards a resolution in future years.
Shifting now from a foreign policy blog to an Investment Outlook blog, it’s fair to speculate how Ben Bernanke will do as the new Fed Chairman. I view him favorably, especially his views on inflation targeting, which if accepted as policy, should help intermediate and long-term bond yields to stay low. Inflation targeting central banks in other parts of the world such as the U.K. and implicitly the ECB, have economies with lower inflation and lower long-term yields than here in the U.S. Admittedly their economies (Euroland) and accounting standards (U.K.) promote lower yields, but inflation targeting is part of the explanation as well since it induces a greater degree of confidence in the admittedly fragile value of paper money.
The key to interpreting Bernanke’s and the bond market’s future rests with so many variables that it’s hard to throw them into one pot and come up with a palate-pleasing recipe: inflation (core or energy impacted?), foreign buying of Treasury and corporate bonds, the fate of the U.S. housing bubble, and the ultimate resting point of the Greenspan/Bernanke Fed, head the cookbook. The Fed has been on a mission for 15 months now to return money market interest rates to neutral and to impart a semblance of normality to the cost of borrowing. In analyzing this journey, PIMCO has for several years now focused on the real interest rate – Fed Funds minus inflation – as the most legitimate indicator of neutrality. Historically trading between 2% and 3%, which would imply a 4½ - 5½% range in nominal headline terms, we have suggested it will be different this time. Because the U.S. economy has evolved into a highly levered finance-based economy, it stands to our reason that this modern day version is more sensitive to changes in interest rates than those of years past . An “it’s different this time” hypothesis is rarely demonstrable from an econometric modeling perspective. There’s little history to model since it involves a jump-step transformation, and so logic must be the ultimate arbitrator. Heightened sensitivity to interest expense in a levered economy seems more than logical to me, but I must admit that more than a 50 basis point increase in funds from this point forward will call our thesis into question. At this juncture, with the market anticipating at least two more 25 basis point hikes between now and Greenspan’s retirement, the real short-term interest rate is close to where we thought and said it would peak nearly two years ago. With January 2007 TIPS trading at a real yield of 1%, the implied level for real Fed Funds over the next 14 months hovers close to our previous forecast. That rate has produced signs of significant economic slowing, but Katrina will fog Alan Greenspan’s glasses for months to come, obscuring as well any observations as to the neutrality of current real short-term yields. It may be best, as featured in last month’s Investment Outlook, to view the effect on a non-Katrina related sector – housing – more than consumer or business confidence-related indicators. If so, peaking to declining prices in some frothy coastal markets may be a sign that current real and nominal yields are starting to bite.
But for those still befuddled, it is wise to rely on a little history as the Fed feels its way along in the dark. It’s certainly instructive to note that over six tightening cycles since 1983, the average Fed Funds increase has been 250 basis points and those increases have taken an average of 12 months time to unfold. Granted this cycle’s beginning yield of 1% was an “emergency” deflationary precaution and more realistically would have settled closer to 1½ - 1¾% if the perceived crisis had not hit the Fed’s radar. Even so, that would place this cyclical tightening in the “8 th inning” to use Dallas Fed President Richard Fisher’s terminology with 4¼% and November/December 2005 marking the historical average levels of extent and time. Economists/investment managers are also aware of the potency of a flattening yield curve shown in Chart 1. By the time 10-year and 2-year Treasuries reach parity, as is almost the case now, the economy is typically slowing and the Fed is at or near the end of its tightening cycle. Only Volcker with his need to strangle inflation out of the system persisted into negative yield curve territory for longer than a few months.
As a final piece of historical evidence that suggests current yields are approaching their peaks, I submit a chart of the 5-year Treasury as a proxy for the “bite” of interest rates, conundrum and all. It is my favorite indicator, but one that is often ignored by the investment public since it takes so long to unfold and doesn’t carry the immediate sizzle of a Fed hike . My take from Chart 2 is that tighter money and higher yields in the intermediate portion of the curve unfold over 1-2 year cycles and generally in the magnitude of 200 basis points (the “Volcker” tightening being the exception). The current upward cycle is now 27 months in duration and 230 basis points in magnitude, enough by historical standards to slow an economy or even produce a mild recession given increased leverage and the exogenous shock of energy prices. Typically an economic slowdown occurs 18 months after the beginning of an upward move in 5-year rates, and this cycle appears to be no exception with industrial production and service-related indicators having peaked nearly a year ago. We are due for what appears to be a 2% or less GDP growth rate in 2006, a rate sure to stop the Fed and to induce eventual ease at some point later in the year. It will likely be Bernanke’s first policy shift and an indicator of his willingness to address the Fed’s dual mandate of inflation targeting and economic growth.
While supposedly a bond market “guru,” as opposed to a foreign policy expert, I must admit I myself am frequently chastened by rereading past Investment Outlooks, and so I approach this one with the usual caution. They don’t always turn out to be true, much like the case of the missing WMD. This doesn’t mean, however, that we stubbornly retain our view in the face of changing evidence. Should Bernanke’s Fed and Bernanke’s economy present a different face than the one we expect in 2006, you’ll be one of the first to hear about it.
William H. Gross