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The Monthly Banker: 8 September 2006

US curve flat as expectations discount an end to rate hikes................


With Labor Day behind us and the August bank holiday but a distant memory, investors are entering what statistically tends to be the year’s most volatile period. 

Various studies have indicated that September is not a propitious month for either stocks or the dollar, while equity markets also have a psychological, though not necessarily statistical, aversion to Octobers.
Opinions differ as to why such seasonal trends should persist in globalised, efficient markets.  However, major market moves do tend to share the common characteristic that they arise from the sudden realisation that conditions have deviated significantly from what had previously been expected.
Bearing this in mind, it is clearly a good strategy to be familiar with what current market expectations actually are in order to make a decent stab at predicting how the actualité might deviate from the consensus.
In the United States the consensus is that the Fed is pretty much done raising rates and recent economic data appear to vindicate the decision to pause.  The smooth acceptance of the August 8th meeting’s outcome, however, belies the depth of discussion, debate and dissension at that meeting.  All in all, it seems the decision was much closer than the lone dissenting vote of Fed new-boy, Jeffrey Lacker, might suggest.
With the Fed Funds rate now held at 5.25% after 17 successive quarter percentage point rate hikes, the US money market curve is pretty much as flat as it gets (see the chart below).  The curve is basically suggesting that there is no more than an incremental risk of further rate hikes over the near term and that rates could actually start falling again in 6 to 12 months time.
Source: Bloomberg
So what are the risks to this scenario?  Well the Fed’s expectation is that slower economic growth will cap what is after all a rather modest upward drift in consumer prices.  The central plank of this view is that the slowdown in the housing market will take sufficient wind out of consumers’ sails for the Fed not to be forced to complete the job it began back in 2004 when the latest (current?) rate hike cycle began.
That consumer confidence is closely allied to the strength of the real estate market is not in doubt.  That link has been made more direct by innovative mortgage products that allow for negative amortisation of loans: rolling up unpaid interest so the the debt outstanding grows over time.
The risk to consumers is that these new loans are subject to regular rate resets and also have a cap on the level of negative amortisation permitted.  Given that the Fed has already increased rates 17 times since those distant days of 1% interest rates, it is not at all uncommon for affected borrowers to suddenly find that their repayments have increased by between 50% and 100%.
With the housing market already slowing far more quickly than had been anticipated, any further consumer stress is clearly not helpful.  We may still be a long way from a recession, but the R-word is most definitely no longer a zero percent probability.
This is essentially the argument that the Treasury market bought into last month.  10-year yields reversed a large part of 2006’s sell-off in just two months, falling from over 5.20% to within an ace of 4.70%.
Looking at where the market stands today, I would say that the small, but non-negligible risk of a recession next year has been discounted to a significant extent.  The least discounted scenario is that inflation continues to trend higher, albeit slowly, and that Mr Lacker suddenly finds his colleagues more willing to discuss their inflation concerns in the public arena.
This is not to say that I think inflation is more of a risk than the demise of the housing market.  It is more a case of believing that the scenario that the market has been busy discounting errs more towards real estate/recession fears than it does to a continuing of the upward inflation trend.  The old adage about “the trend being your friend” has rather more than a grain of truth to it.
The state of the housing market is also a concern of the Bank of England’s monetary policy committee.  However, the MPC appears somewhat perturbed that reports of the housing market’s demise last year were significantly exaggerated.  Indeed, thanks to what has been described as the Bank’s free option (hold that thought), the UK property market barely achieved any sort of landing last year after booming house price inflation topped 25% in 2002.
The free option refers to the suggestion that the Bank of England effectively underwrote the housing boom by cutting rates last summer on no more concrete a pretext than that property price growth was slowing and appeared set to slip into reverse.  The rate cut may only have been by 25 bps, but it was sufficient to convince those pesky buy-to-letters that property was once again a one way bet.
This rebound in the property market actually makes it quite difficult to describe the consensus view of the UK economy in just a few words.  A more erudite narrative comes from the money markets which, as you can see below, are busy forecasting further rate hikes with the consensus looking for the next increase to occur in November.  The curve is quite unlike the US dollar LIBOR example above.
Source: Bloomberg
The crux of the matter is that given the housing market’s fundamentals, MPC members are markedly less inclined to dismiss the gradual rise in inflation as a statistical aberration.  This is despite the fact that their American cousins have bought into a very similar argument.
This is somewhat ironic, because UK inflation is actually lower than US, with core prices rising by just 0.9% over the past year.  Nevertheless the UK markets have chosen to discount a scenario in which rates could rise by a further 50 bps or more over the next year. 
Such hikes might suit wealthy Arab investors who see the London property market as an unequalled currency play and tax break.  However, not every postcode has matched the 20%+ gains registered in Holland Park and Notting Hill over the past year.
The World Cup inspired shopping boom in the UK has also been “seasonally adjusted” and no longer appears to have been the retail-fest originally reported.  Despite this, UK Gilt yields markedly failed to match the sharp fall in yields across the pond and are now just about the cheapest they have been relative to the US in almost a year.
On the face of it, a purely risk/reward analysis would suggest that Gilts should outperform Treasuries as economic expectations fail to confirm the somewhat extreme expectations currently discounted for both markets.
The trouble with this view is that September is historically actually a rather good month for Treasuries.  However, as with the seasons themselves, perhaps the September bond rally came a little early this year….in August to be precise.