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Friday, July 14, 2006

The Sacrifice Ratio

Interesting article by Casey Research Inc. on the so-called "Sacrifice Ratio" which the Fed supposedly weighs carefully. Basically it says the sacrifice ratio right now is so high, at "4", which explains why the Fed has chosen to hike interest rates bit by bit (17 straight 25bps hikes) instead of reigning in inflation at once. Which means more rate hikes. Basically an added reading to Freddy's post "The Bear Case". Very interesting... read on!

TERENCE
The Sacrifice Ratio

Whither interest rates?

That's the question everyone wants the answer to. Each time the Federal Open Market Committee (FOMC) has a scheduled meeting, economists and analysts tie themselves in knots trying to anticipate what will happen. Even between meetings, the process never lets up. Notes of the previous gathering are pored over, and every word uttered in a speech by a member of the Board of Governors is scrutinized for its hidden meaning.

No wonder. Interest rate decisions by the Fed have a profound short-term effect across the markets, from stocks to gold to the value of the dollar in international trading.

The factors that contribute to the decision-making process are many, but one of the most important is also the most arcane. Few have heard of it, even among relatively sophisticated investors; fewer still watch it closely.

It's a simple number called the sacrifice ratio.

If that sounds a bit ominous, that's because it is. It means that somebody or something is going to be sacrificed in order to achieve some other end. That's the way of the world in a "controlled" economy such as we have today.

Control of the economy has been one of the primary functions of the Federal Reserve since it was created in 1913. The truly free market was too unpredictable, too subject to wild swings, argued the founders (a group of the nation's leading bankers, acting primarily out of self-interest). The Fed was needed to smooth out the rough spots and to promote, in its own words, "objectives such as stable prices, high employment, and economic growth."

(Considering that, since the birth of the Fed, we've had one Great Depression, a number of recessions, the hyperinflation of the late '70s, and a 96% decline in the purchasing power of the dollar, some might be tempted to ask in what way it's been doing its job.)

The Fed pursues its goals by raising or lowering the prime interest rate--the rate it charges its most favored customers, and from which other lenders take their cue--and by deciding whether to increase or decrease the money supply. In general, lower interest rates and more dollars pumped into the system heat up the economy, causing a rise in both employment and inflation. Conversely, when interest rates rise and money tightens, the economy cools, unemployment goes up and inflation comes down.

That's where the sacrifice ratio comes into play.

The actual formula the Fed's math majors use in computing sacrifice ratio is extremely complicated. For our purposes, though, what we need to know is what it expresses. In greatly oversimplified terms, it is the amount of extra unemployment that will result from an interest rate hike, divided by the amount future inflation will be lowered by the same rate increase.

In other words, when you do this kind of economic tinkering, there's always a tradeoff. Are you willing to swap people's jobs for a curb on the cost of goods and services? At what point, and to what extent? This is the Fed's perpetual dilemma, where to make that trade.

Worse still, the Board has to make its decision based on what it thinks the situation is going to be in the future. It has to look out a year or more and, for example, mount a fight against inflation that hasn't yet happened.

The sacrifice ratio (SR) is a small, single-digit number. Think of it as the percentage rise in unemployment that will result in one year from a corresponding fall in inflation. Thus, if SR=1, a one percent drop in inflation over the coming year will theoretically produce a one percent bump in unemployment.

SR=1 is actually a pretty desirable equation. If the Fed could keep it there by interest rate manipulation, thereby limiting both inflation and unemployment to one-percent ups and downs, they'd be very happy campers.

Of course, they can't. Nothing in the real world works so nicely. Lag times may be longer or shorter than anticipated, there may be a terrible shock somewhere on the world stage, inflation may stubbornly continue despite an economic slowdown ("stagflation"), and the law of unintended consequences is always set to weigh in at any given moment.

What is clear is that the higher the SR, the more difficult it is for the Fed to engineer a positive result, with high and rising representing its worst nightmare. Today, the number stands at around 4, a high number that appears to be only headed higher. (In the mid-1980s, it was between 2 and 3.) It means, roughly, that if our time frame is a year, in order to bring inflation down by 1%, we will have to tolerate an unemployment jump of 4%.

Which is unacceptable, of course. It would require a huge boost to interest rates, and create a concomitant recession of dreadful proportion.

Ever wonder why the Fed has increased rates a skinny quarter-point per meeting? This is a big part of the answer, the time factor. Facing what it perceived as a dangerous inflation level down the road, it could have upped rates all at once, yielding a period of intense, concentrated economic pain, or done it in tiny steps, stretching the pain out over several years, at a less intense level. Otherwise known as the "soft landing."

Naturally enough, the Fed chose the latter course rather than commit collective suicide.

In the presence of an elevated sacrifice ratio, the choice was made to fight high inflation preemptively, rather than confronting it when it actually erupted and risking a severe economic dislocation. Additionally, the belief is that a policy of gradualism will also serve to lower the SR over time.

It might work; then again, it might not.

But one thing is for certain, the Federal Reserve Board--and especially Ben Bernanke, who takes the sacrifice ratio very seriously--will stay the anti-inflationary course.

And that answers the question posed at the beginning of this article. Whither interest rates? Up. Past performance suggests that the Fed, when it comes to the fork in the road offering a choice between Overshoot and Stop Short, has a pronounced tendency to head down the former.

So don't expect the FOMC to call a halt at the first signs of a slowing economy. The likelihood is that interest rates are headed higher, and for longer, than most people imagine. Until, perhaps, the sacrifice ratio begins to fall.

Opportunities Arise with Expected BOJ Rate Hike


The BOJ is meeting today and is poised to hike interest rates for the first time in 6 years to 0.25%. If this happens, this will be more than just the scant 25bps rate hike that it is... it symbolizes that Japan has defeated deflation and is on a strong economic recovery, and might be a start of a long-term trend. It might also be officially the end of the yen carry trade.

When interest rates in Japan were effectively zero and the yen was weak, the BOJ was actually allowing investors to take money for free and creating so much liquidity that asset markets like emerging market equities, bonds and real estate rose so much. People have already anticipated the end of the yen carry trade, and emerging market (EM) currencies like the Turkish Lira, Indonesian Ruppiah, RSA Rand and Polish Zloty have already fell.

With the official announcement of the rate hike and the end of the yen carry trade, expect more weakness in EM assets. The Japanese stock market has also fallen due to rate hike jitters, some people fear that rising borrowing costs will stifle the rebound, though we think this is highly unlikely as the economy and corporate balance sheets are much stronger than 6 years ago. We feel the current and expected further correction will be an opportunity to buy ETFs like EWJ, EWZ and FXI. We feel these 3 markets have good domestic stories that will allow them to have better rebounds from a correction. The problem is the timing... how deep will the correction be?

TERENCE

An Open Letter to Ben Bernanke

Below is copy of an open letter to Ben Bernanke from MorganStanley's Stephen Roach. I believe that Mr. Roach raised an important issue on the Fed's “flip-flopping” behavior on policy bias. Some consistency would surely be appreciated Mr. Bernanke.

Packy

July 12, 2006

Dear Ben,

It’s time to take a deep breath. You are off to a rocky start as Chairman of the world’s most powerful central bank. Your policies are not the problem. Given the über accommodative legacy you inherited from your legendary predecessor, the three 25 bp rate hikes in each of the three policy meetings you have chaired have made good sense. The issue is more subtle —- your ability to send a consistent message to financial markets. This is a critical element of your job description. It defines your credibility as a policy maker as well as the credibility of the great institution you now lead. In the end, without credibility, a central bank is nothing.
You know this, of course. As one of the world’s leading academic apostles of inflation targeting, you have long stressed the merits of anchoring financial market expectations of monetary policy with a simple price rule. With price stability now widely accepted as the sine qua non of central banking and with core inflation rates in the US and around the world not all that far away from the hallowed ground of price stability, there is considerable merit in underscoring a determination to preserve the hard-won gains of the past 25 years. This could well be your golden opportunity.
With all due respect, Ben, you are close to squandering that opportunity. A transparent policy rule has real merit in minimizing unexpected and undesired swings in financial markets. But any such rule is as good as its disciplinarians — the central bankers who are charged with delivering the message to the public at large. It pains me to say this, but your message has been all over the place.
What I am alluding to are several reversals in your official pronouncements in the past couple of months. It all started with your 27 April testimony before the Joint Economic Committee of the US Congress, where you openly entertained the possibility of an “unjustified pause” in the Fed’s monetary tightening campaign. That was followed by your 5 June speech at an International Monetary Conference in Washington DC that sent a clear warning about your concerns over “unwelcome developments” on the inflation front. Then there was the policy statement immediately after the 28-29 June FOMC meeting, underscoring the Fed’s forecast that a “…moderation in the growth of aggregate demand should help to limit inflation pressures over time.” Nuanced or not, in this brief two-month time span, your official statements have gone from dovish to hawkish and back to dovish again. Such inconsistencies raise serious questions about your credibility as the world’s leading monetary policy maker.
Speaking of that, you and your colleagues at the Fed must be mindful of the international context and consequences of your posture. Your back-and-forth waffling comes at a critical juncture in the global monetary tightening cycle. Jean-Claude Trichet of the ECB surprised the markets with his own tough talk last week — in effect, pre-announcing another rate hike for August, a month when Europe is normally at the beach. At the same time, the Bank of Japan’s Governor Toshihiko Fukui has also been talking tough for several months, signaling the end of a seven-year zero-interest rate regime and the onset of a long-awaited normalization of Japanese monetary policy. His first step could well be imminent — most likely at the BOJ’s upcoming 14 July policy meeting.
Ben, that puts the consequences of your recent reversals in a very different context. Global investors are perfectly comfortable with the notion that the Fed, which began its tightening campaign long before other major central banks, would be the first to attain its objectives. The idea of the “policy catch-up” by foreign central banks has long been embedded in the consensus view of a cyclical dollar weakening. However, to the extent that the European and Japanese central banks stay on message while you do not, the monetary policy credibility factor could well shift away from the United States. Given America’s outsize current account deficit, a relative credibility erosion could spell sharp downward risks to the dollar — and equally sharp upside risks to real long-term US interest rates. That’s the last thing an asset-dependent, overly-indebted US consumer needs. A resumption of the greenback’s weakness in recent days suggests that you can’t take this possibility lightly.
It was always going to be difficult to wean the markets from the measured Fed tightening campaign that has unfolded without interruption over the past 24 months. When the federal funds rate was 1% in June 2004, the next move was a no-brainer. But now at 5.25%, it is obviously much trickier. The key for you is not to let your understandable sense of uncertainty over the economic and inflation outlook morph into an on-again, off-again assessment of policy risks. This was supposed to be the sweet spot in the policy cycle for inflation targeters like yourself. Lay out the metric you are targeting, provide a clear assessment of the risks, and then let the policy rule generate the unambiguous answer. Easier said than done, I guess.
I think the best thing you can do at this point is to borrow a page from the Greenspan era and make a simple statement of your policy bias. For example, as long as you perceive inflation risks to be on the upside of your tolerance zone, you and your colleagues can endorse a tightening bias. Conversely, if inflation risks tip to the downside, it may be appropriate at some point to announce an easing bias. The bias statement works best when the policy rate is near the so-called neutrality threshold. It is less appropriate when the overnight lending rate is far away from such an equilibrium. In the current context, the verdict would be clear — a tightening bias is in order until inflation risks recede. There’s nothing automatically actionable about such a bias that locks you into a move at each and every policy meeting. There is ample leeway to pass on a policy move and still maintain your concerns.
There may well be a silver lining in your unfortunate experience of the past couple of months. Central banking is as much art as it is science. In that vein, it is equally important to be mindful of one of the major pitfalls of the current financial market climate — seven years of one asset bubble after another, driven by the mother of all liquidity cycles. It is high time to bring this dangerous state of affairs to an end. These are the same bubbles that spawn wealth-dependent distortions to saving and massive global imbalances. Not only must you commit to price stability in the narrow sense of your CPI target, but you and your central banking colleagues in Europe, Japan, and China must be equally willing to commit to an orderly withdrawal of excess liquidity in order to put a seriously unbalanced world on safer footing. That underscores my recommendation to maintain a tighter policy bias at low rates of inflation than a strict price rule might otherwise imply. If that’s what it takes to break the moral hazard of the “Greenspan put,” it is a risk well worth taking.
I guess in retrospect we should have seen this coming. After all, history tells us that transitions to a new Fed Chairman invariably don’t go well. The “transition curse” saw the equity market quickly challenging Alan Greenspan with the Crash of 1987, the bond market promptly testing Paul Volcker, and a dollar crisis immediately confronting G. William Miller. The so-called risk reduction trade, which commenced in early May, could well go down in history as the Bernanke test. There’s nothing like unforgiving financial markets to find the Achilles’ heel of a new central banker.
The good news is that you have another important chance to recover your credibility — your midyear appearance in front of the US Congress slated for 19 July. The bad news is that this may be your last chance for a while. A third reversal could well spell a serious and damaging setback to Fed credibility. A serial bubble blower was bad enough — the last thing world financial markets need is a serial flip-flopper.


Sincerely,


Stephen S. Roach
Chief Economist
Morgan Stanley

Thursday, July 13, 2006

The Bear Case

Maybe we can also do a vote on who believes FED will raise or not raise in August...


Good article for a bearish outlook: (thoughts of John Maudlin)

1. Most likely another round of tightening as doing it now will mean a less aggressive stance in the future, if inflation becomes more of a problem.
2. Appointment of Mishkin. Inflation hawk.
3. Economy slows down - bad for market. FED continues rate hikes - bad for market.

FastFred
The End of The Fed Raising? Not.

But first, a few quick comments on the markets. After the large ADP payroll estimate of job growth (385,000) the expectations for today's employment number was a disappointing 122,000, which sent the stock market into a funk. The bond markets rallied as we saw lower yields almost across the board, as a weaker economy will mean lower long-term rates.

But 122,000 is still not all that weak, except in comparison with the ADP numbers. Next week we will see the inflation numbers, and I expect them to still be in the plus 2% range where the Fed feels uncomfortable. Let's quickly review why I think the Fed will raise rates again in August and maybe even after that.

First, there is that obscure item called the "sacrifice ratio." How much pain in terms of a slower economy and lower employment do we take today to make sure we do not have excessive inflation in the future? Higher inflation in the future will ultimately mean even higher rates and a possible deep recession, as the Fed would then have to tighten aggressively. It is a trade-off or sacrifice. There is a number which characterizes the risks and rewards, called the sacrifice ratio, and today and for the last few years it has been high, which is why the Fed has continued to raise rates.

This is illustrated by the following sentence from a speech made this last week to the British House of Commons by Fed vice-chairman Donald Kohn.

"I think we are very well aware in the Fed that there is some risk that we would tighten policy more than necessary and that it might induce weakness in the economy... [but] there is a greater risk from not tightening." (Source: The Gartman Letter)

The headline in the paper was "Kohn Aware of Risk of Tightening Policy Too Much," but the sentence above clearly illustrates that he is prepared to do so if they think inflation is a future issue.

Second, the Fed is moving to inflation targeting. It is so far silent about this topic, but you can read the tea leaves. Bush just appointed Dr. Fred Mishkin to a recently vacated Board of Governors position. Just another academic economist? Hardly.

Mishkin was the co-author of Bernanke's main economics textbook. One of the main points of the book was that central bank policy should be targeting inflation, with upper and lower bands of what the inflation number should be. (Also, I am pretty sure that there was a chapter in that text on the sacrifice ratio.)

So, Ben has a close friend who also believes in inflation targeting. There are a number of other new names on the board of late. Care to make a wager on how they feel about inflation targeting? If you read their speeches, you could certainly be forgiven if you come away with the impression that the recent rise in inflation is their #1 concern.

There is another appointment coming up for a recently vacated spot. Fed watchers should pay close attention to who Bush nominates, as it could mean a major sea change in the way the most powerful central bank in the world operates. This is more than a mere academic exercise of changing one group-think central banker with another. A Fed which openly announces inflation targets is a profoundly different Fed than the one which Greenspan chaired.

And while we are on the topic of inflation, Bill King sent this very interesting note from HSBC's Stephen King & Janet Henry writing on global central-bank vexation over inflation. It succinctly states the problem that I have spent a great deal of time on this year:

"The definition of inflation is crucial. The Federal Reserve's preferred measure has understated inflationary pressures relative to the methodology utilised by the European Central Bank: perhaps the Fed should have been raising interest rates a bit more aggressively two years ago...

"As for measurement, we examine in some detail the different baskets of goods and services that appear in alternative measures of US inflation. Put simply, some baskets contain lots of apples whereas others seem to focus mostly on pears. We reach two broad conclusions. First, the Fed's preferred measure of inflation - the so-called personal consumers' expenditure deflator excluding food and energy - paints the most flattering picture of US inflation trends. Second, the best "early-warning" measure of US inflation is not even widely published: it's the Bureau of Labor Statistic's harmonized measure of US inflation, using the methodology familiar to those who monitor inflationary developments in Europe. This measure was rising rapidly through 2004 when both the CPI and the PCE deflator were barely twitching...

"Perhaps the world economy has an Austrian-style problem. Loose monetary policy in the early years of this decade may have kept the deflationary wolves at bay but, by encouraging excessive gains in asset prices, may have contributed to both excessive consumer leverage and too high a level of global demand.

"If asset prices, notably house prices, now have to fall, they will come down either in nominal terms or, via inflation, in real terms. Central banks determined to stamp on inflation will encourage bigger nominal asset price declines and, by doing so, will raise the risk that current inflationary fears will be replaced by deflationary dangers next year: in response, this year's monetary tightening should be followed by renewed rate cuts in 2007." www.hsbcnet.com/research

The different methodologies of calculating inflation in the US and Europe is a primary reason for Europe showing less GDP than the US over the past several years. The currency market was not fooled. Further, you can bet the Fed governors and economists are aware of these various methods which suggest inflation is a problem. It is just another reason why they sound as hawkish on inflation as they do.

Commodities, Bonds and Interest Rates

Equities right now look like they are set for further declines due to weak earnings (Alcoa, EMC, Genentech) as we had expected, and we expect the Fed to pause in August when it sees the earnings growth slowdown allowing equities to rally. How about the other asset classes, namely commodities and bonds? How will they perform in the near term?



Based on the weekly charts, commodities as represented by the CRB index have their upward trend intact. MACD has been losing momentum the past few new highs but no clear divergence is established. On the other hand, treasury yields still have their upward trend intact on the weekly charts but looks toppish and there is a clear divergence forming on the daily.

We think that the bond market is already showing signs that people are expecting a rate pause in August. Bond prices (not yields) and commodities have an inverse relationship. At the beginning of an economic cycle, when interest rates are bottoming out or low, bonds are expensive and the returns are low... commodity producers can thus afford to keep their money in inventories of commodities. As the economy improves, they build up more inventory in anticipation of better sales, while interest rates go up to control inflation and bond prices move down. Hedge funds also join in on the fun, buying up commodities in anticipation of a rush in prices.

However when commodity prices become expensive and interest rates are high the economy will eventually slow and interest rates will have to eventually go down. Here the trend reverses and bond prices will start to rally from the bottom and commodity producers and hedge funds will find better returns for their money from the bond market and rotate out of commodities. We feel this is going to happen in the coming months as interest rates come to a pause with the possibility of going down eventually. We think any strength in commodities and commodity stocks is a chance to sell, given where we are in the economic cycle. BUY BONDS!!!

TERENCE

New Interactive Features

Guys we are pleased to announce that our new interactive features, namely the message forum and the vote caster are now available. Please look for the buttons at the right side of the screen.

TERENCE

Wednesday, July 12, 2006

Yield Curve Lessons Part III

And Php 1.68 it is. A more than 20% premium from the IPO price of Php 1.36 on a rainy Wednesday is definitely something not to be scoffed at.

Finally, the small investor of the Philippines can now participate in the grand scheme of stock market swings. And not only that. By having itself listed, COL also gives the investors a fresh company to invest in. Years ago, your broker down the street would always tell you to invest in "sunshine" industries. Now, tell me if this ain't "sunshine" enough.

*****

Here is the last installment of our lessons in yield curve.

Long-term rates are comrprised of two parts: the expected future interest rate plus a risk premium. Furthermore, the risk premium is equal to the sum of real interest rate risk premium plus inflation risk premium.

In the past article we said that the Fed can only control the short term rate and not the long term rate. However, this is more theory than practice. The past few months we can see how the Fed was able to influence the long-term rates by increasing the inflation risk premium. Bernanke had been for months barking like a dog on a possible runaway inflation.

Now, by influencing the long-term bought the Fed some breathing room. This enabled the Fed to increase the short-term a little more and somehow prevent that dreaded yield curve inversion.

Bryan

Commodity ETFs


When State Street Global Advisors (SSGA) launched streetTRACKS Gold Shares (GLD) in late 2004, it became the first Exchange Traded Fund designed to track a commodity. The Fund provided a cost-effective alternative to retail investors who wish to participate in the commodities market. GLD's launch was so successful that other asset management firms followed SSGA by introducing similar commodity specific ETFs.

Here are other Exchange Traded Funds that attempt to mirror the prices of commodities:

These and other specialty ETFs provide us with a vehicle to hedge against commodity prices and the ability to participate (cheaply) in global investment themes. Just like the US index-based funds (SPY, QQQQ), commodity ETFs trade throughout the day, can be bought on margin and can be shorted like an ordinary stock.

Obviously these offerings carry a higher level of risk. Commodities are inherently volatile so expect the same violent swings on the stock price. Always check the fund's portfolio mix before buying or shorting. For more information you can visit www.mornigstar.com. Good Luck!

Packy

Second Half Outlook from Business Week

Businessweek had its 2nd half outlook for us and global stocks, which you can access here http://biz.yahoo.com/special/pf071106.html. We will post our comments on their articles shortly.

TERENCE

Tuesday, July 11, 2006

Yield Curve Lessons Part II

This is the trio to beat in the next two years! President Bush nominated able and accomplished assistants in Gov. Bernanke to print his money, and Hank Paulson as his cheer leader.

Paulson used to be the head of Goldman Sachs. His nomination confirms the fact that like former secretary Robert Rubin (also a product of Goldman who also became treasury secretary), a good strategy for an investment bank to assure its investors of their returns is to control the economy itself. He is for continuous growth amid debt funding. He admitted to be a team player.

Bernanke, on the other hand, is famously (or notoriously) known as "Helicopter Ben" for his use of Milton Friedman's "helicopter drop" of money into the economy to fight deflation. If Greenspan is a money printing addict, this one's always in the pot session. One of his most famous quote goes : "people know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation."

The pot is now in session!

*****

Back to the yield curve.

There are several shapes the yield curve can form. It can be Normal, Steep, Flat, or Inverted. The normal shape points to stable economy in the future, expecting lesser disruptions and uncertainties. The steep shape points to the economy improving quickly in the future. The flat curve has a high percentage of preceeding a weak market in the future although it is not guaranteed. And last, the inverted curve is as we said is abnormal because it is pretty stupid to take on lesser return for taking much more holding period risk.

Now let us dissect the yield curve formula. The simple formula for computing for future rates is by dividing the square root of the present annual rate by next year's expected rate then subtract it by 1. For example, the annual yield on a 1 yr bond is 5% and on the 2 yr bond is 5.5%, then the implicit or forward yield(forward rate) in year 2 is 6% as shown in the formula above.

The inverted yield curve is of major concern because it historically preceeds recessions. So you ask why not the Fed just raise the long-term rates to avoid inversion? The thing is, it cannot. The Fed can only control the short-term rates.

The beef here is that as short-term rates become close to long-term rates, banks would experience margin squeeze. In simple terms, margins of banks are based on the difference between loan rates and deposit rates. They practically lend out the cash that you deposit for higher rates, definitely higher than what the bank gives you. Now, most of the cash that is deposited in the bank has to be invested in safer instruments. Again, in this case, the long-term US treasury bond will be the instrument of choice as it is the safest, returns are almost sure and in trader terms, liquid. Unless you deposit it in the Bank of Wafah Dufour, your money will probably be loaned out again to Osama.

So basically the loan rates that banks charge is based on the long-term rates. Thus, the higher the long-term rates go, the better margins for banks, the more aggressive they will loan out. The lower long-term rates go, the more unprofitable it is for banks which may cause credit crunch that may crimp the economy's growth.

Or should I say recession?

More on the yield curve in our next class.

Bryan

Monday, July 10, 2006

Ben wants some lovin'


Let's face it... everybody wants to be loved in some way, including our good friend Ben. First he inherited the mess that was the US economy from Alan Greenspan, rampant with asset inflation (or dare we say bubble), and when all the fun finally ends Ben will be remembered as the chairman under whose regime it happened and he will be hated for it. So naturally Ben hiked interest rates and released some hawkish comments early in May, which spooked all asset classes but the US$. This sort of fixed the yield curve problem for the meantime, which was always threatening to invert since December. This also gave him room for another rate hike, which he executed, in late June. But the main reason Ben did this is he wants to be loved.

However, he is also aware of the lagged effect of interest rate tools and knows that the economy is already slowing down. Already, economic data coming out is already starting to point more towards that... and you very well know what everybody is cheering for... so again Ben wants to be loved. Along with the June rate hike, which we believe will probably be his last one, he released some dovish comments, a 360 degree turn from his May comments.

We might as well see a pause in August 8's Fed meeting, by that time earnings season will already be in full swing and we should see some slowing earnings growth. Take note analysts are slow to ratchet up their estimates at the beginning and also slow to take them down when earnings are peaking. This is why we are expecting more volatily... poor earnings will probably drag markets down as we are seeing now, but a Fed rate pause will be a catalyst for a rally.

TERENCE

How Dow are you?

It is a smelly predicament for France's David Trezeguet as his penalty kick found the upper crossbar and bounced just on the goal line and was decided out by linesmen. A sad story indeed as his limited playing minutes only resulted in heartache. He replaced Zidane in the penalty shoot out as the latter was given a red card and ejected out of the field. Zidane's head butt to the chest of Italy's Materazzi was not seen by referees but was caught on tape. And I thought replays were only used in basketball shot clocks.

*****

We definitely have interesting times in our hands in Asia. We have Koizumi giving a speech at Graceland while singing the jailhouse rock. He says he idolizes Elvis. Damn he sure was drunk while giving a speech on tv!. Then a week after his speech, North Korea sneaks in a nuke test. Washington is definitely hinting on "We Should Definitely Invade Them Part III." And next week, the party will be over.No more freebies from the land of the rising sun. Starting next week, it will be the Land of the Rising Rates as the BOJ will be raising interest rates for the first time in 15 years! Good luck to all of us parasites!

*****

The trend is our friend so the Dow theory says. If you are a trader, how Dow are you?

The theory was developed by Charles Dow, an investigative reporter turned NYSE member. In summary, his theory aims to identify the primary trend of the stockmarket and how to be able to ride the big movements. As stockcharts.com explains it: "They understood that the market was influenced by emotion and prone to over-reaction both up and down. With this in mind, they concentrated on identification and following: identify the trend and then follow the trend. The trend is in place until proved otherwise. That is when the trend will end, when it is proved otherwise."

This theory uses 2 major averages that determine which direction the market will most likely make its big move: (1) Industrials index; (2) Transportaion Index. Both of these averages must coincide for us to determine the general market's direction.
Here is the chart of the Industrials. Where do you think this chart will go?
And here is the chart of the Transports. Where do you think this chart will go?






Looks strong to me. Hey, who spilled the Kool Aid? More on the Dow Theory in the coming articles.

Charts courtesy of www.stocksharts.com

Bryan

Ben and the yield curve...


This graph was in the latest edition of Mr. Model, an economics newsletter by Robert F. Dieli. It shows the effect of Federal Funds Rate policy on the US economy. It also highlights the periods where the yield curve was abnormal (inverted).

Dr. Dieli arrived at the conclusion that when the fed funds are north of 5.50% the US economy does not fair too well. We can see that the last six recessions happened shortly after the yield curve inverted and the Fed Funds rate was above the 5.50% level. The only exception was the 1982-1990 expansion period. However, the main difference between now and the mid-80's was that core inflation was on a downtrend. Today we face continued inflation pressure as energy prices advance to record territory. The odds of core inflation peaking or reversing in the short-term are diminishing rapidly as crude futures move past $75.

So is it all gloom and doom? Its starting to look like it. But there is still a chance that Mr. Bernanke can hold the line and navigate the US economy to a soft landing. If June-July PCE inflation numbers stay within the FOMC's comfort zone of 2% maybe he would stop raising rates. This will give us an environment similar to the mid-90s where Greenspan was successful at taming inflation and avoiding a recession despite having an inverted yield curve. If Ben can mimic Alan's success, then the Fed's reputation as an inflation fighter will be enhanced.

I will leave you with the same questions Dr. Dieli ended his newsletter with: Can the FOMC engineer a solution that keeps us within hailing distance of the 5.50% line? How will Ben Bernanke restrain inflation and avoid an inverted yield curve with just one tool?

Packy