Once again we have a weak dollar helping to push the price of crude oil even higher (see Bloomberg article, see first WSJ article on crude, second WSJ article on the dollar). In the CNBC video below, the technical analysts Nicole Elliott is absolutely beside herself, and even giddy at times, regarding the absurdity of the move in 2-year U.S. Treasuries. She eventually comes to the conclusion that the central banks have lost all control of the setting of interest rates, not to mention the long bond and interbank loans which have been outside of their control for a while.

Source: CNBC Video
Yet the 44.4 basis point move between June 5-8, along with the recent move in the Fed funds rates, are being dismissed by some firms that trade directly with the Fed, implying that it is simply speculators that are driving rates up (see Bloomberg article). Many dealers go on to predict that the Fed will hold tight well into 2010. Maybe so, but does it matter? While the Fed has recently retreated from seeking debt-issuing power to help control inflation (see Bloomberg article), the markets certainly are nervous about what they are seeing, regardless of the policy and wishes of the Fed. The TIPS market has also been active (see previous post).

Of course, what many traders are seeing and are nervous about begins with the unprecedented amounts of cash that is flowing into the world economies, much of which will eventually trigger higher inflation, higher taxes, and lower profit margins. To make matters worse, there is a feeling that much of the spending and printing is not necessary, and even worse, that no one at the Fed is really even minding the store. For instance, in the YouTube video below, one politician questions the Inspector General of the Federal Reserve. During the questioning, the Inspector General seems to have no idea where the trillion-plus dollars the Fed has put into the system actually ended up, or who received the money. There also seems to be no postmortem or investigation on the impact of not bailing out Lehman Brothers, or auditing of any off-balance sheet transactions.


Source: YouTube
Given the market reactions, the inflation-driven moves are beginning to appear a little more obvious (see excellent Michael Pento greenfaucet post), even if the size and timing are still under debate. Yet the moves can happen quickly. Just ask those trading the 2-year Treasury, or those who were looking to lock-in to a 30-year mortgage under 5 percent just a few weeks ago. This certainly seems encouraging for commodities long-term, and even short-term, regardless of the current rallies. Just think if demand actually catches up?

The Libor rate is once again signaling problems, but this time it is unclear who has the problem (see WSJ article). Just a few months ago there was some concern that Libor was understating the true borrowing cost (see previous posts here and here). Since the British Bankers' Association collects data from banks regarding their borrowing costs, it was speculated that banks were reporting costs that were actually lower than their true cost, mainly to keep from signaling to the market that others might be worried about potential problems with their company (ie., forcing higher lending cost). Now on Monday of this week, the rate for the 28-day Federal Reserve lending was 3.75 percent, higher than the one-month dollar Libor rate of 3.19 percent. This would normally not make sense given that the Federal Reserve requires collateral to secure the loans, whereas the short-term Libor lending between banks does not. Of course, within the last week Treasury yields have nearly disappeared as investors moved cash from money market funds to Treasuries after worries of some money market funds "breaking the buck." No doubt that as the government continues to debate possible bailout plans, and the Federal Reserve continues to find new ways to inject liquidity, anomalies such as what is being observed in credit markets will continue to keep investors scratching their heads and looking for safe places to park their money.

The 3-month London Interbank Offered Rate reached 2.81 percent Monday, the highest it has been since mid-June (see Financial Times article). The Libor is elevated compared to the Federal Funds rate, currently at 2 percent. The difference of 81 bps between Libor and the Fed Funds rate compares to an average spread of just 12 bps that occurred before the beginning of the credit crisis last year, indicating that there is still a lot of stress in the financial system, and that banks are still restructuring. Given that the market has been lowing its expectation of a Fed increase, the rising Libor may be an indication of more problems ahead in the financial system.

There is a interesting short paper written by Ryan Faulkner that is available for download at Faulkner Capital or at Barclay Hedge (registration required). In the paper, Faulkner discusses the cost and consequences of the FOMC's decision late last year to lower interest rates and keep them low. While Faulkner recognizes that lower rates have provided short-term relief for the financial markets in the wake of recent credit problems, he argues that the consequences of price instability will present consequences for the markets that may have longer lasting negative effects.

Faulkner provides a comparison to the problems of the mid-1970s (I know, the stagflation comparisons are everywhere, but hang in there). At this time the real federal funds rate was negative. During, and shortly after this period, commodity prices increased rapidly. Now fast forward to 2001 and a similar trend was developing - the real federal funds rate was also negative, and commodity prices began their assent upward to the point that in June of 2004, commodity prices were rising on average 13.5% over the previous 12 months.

As rate increases took the fed funds rate from 1.0% to 5.25%, prices for commodities began to decelerate, but the move was short-lived as the Federal Reserve began drastically cutting rates in September of 2007. Not surprising, commodity prices once again took off, with real prices rising 31.9% from May 2007 to May 2008. In fact, while numerous reasons are often given for higher commodity prices, empirical studies looking at the data show that commodity prices can be modeled as a monetary phenomena (see Barsky and Kilian, 2000). Often the rise in commodity prices were either directly or indirectly driven by monetary expansion.

Of interest is that during economic expansions, it is normal that demand for commodities will increase, with commodity prices following suit. Yet if monetary policy is such that it continues to encourage growth beyond what is normal for the economic environment, then markets run the risk of entering bubble territory, such that demand and prices continue to rise, even when not justified by current economic activity. We certainly appear to be entering, or are in the midst of such a reaction to low interest rates. How do we get out of this cycle? Two scenarios come to mind and are mentioned by Faulkner. For one, the Fed could begin raising rates, but the impact on the credit markets, and subsequent fallout for the entire economy, is difficult to predict and something the Fed appears to believe is not the best course of action, or simply something they are unwilling to risk. As an alternative, the Fed could continue to keep rates low, but this scenario is likely to cause the markets to take matters into their own hands, such as selling Treasuries in mass as inflation continues to rise.

Given recent Fed moves, it is likely that the markets will need to take matters into their own hands. Regardless, the impact and repercussions may be long lasting and are likely to repeat themselves if the Fed continues to give the impression of being more interested in managing quarterly GDP numbers, and less on controlling inflation and supporting the dollar for fear of occasional lower growth. Granted, the current Fed has its hands tied somewhat, so current motivations may be based more on walking the credit tightrope, and less on any long-term bias. Only until the current credit issues are behind us (or at least manageable), and commodity prices are somewhat controlled (it is too soon to tell if the current correction will continue and last), will we get to see whether the current Fed chairman is of the Alan Greenspan or Paul Volcker mold, or some hybrid in between. In the mean time we have to wait and hope that no rate move is the right move.

Reference:
Barsky, R. B., and L. Kilian, "A Monetary Explanation of the Great
Stagflation of the 1970s," NBER Working paper, 7547 (http://www.nber.org/papers/w7547), 2000.