31 January 2008 – The Aleph Blog

Seven Brief FOMC Notes

Posted on 31 January 2008 by David Merkel

1) From an old post at RealMoney:

		David Merkel
		Nominate Fisher for the ‘FOMC Loose Cannon’ Award
		6/1/05 4:05 PM?ET

It was pretty tough to dislodge William Poole, but if anyone could win the coveted “FOMC Loose Cannon” award in a single day, it would be Richard Fisher, after suggesting that the FOMC was “clearly in the eighth inning of a tightening cycle, we’ve been doing 25 basis points per inning, it’s been very transparent, and very well projected by the Federal Open Market Committee under the leadership of Chairman Greenspan,” and, “We’re in the eighth inning. We have the ninth inning coming up at the end of June.” [quoted from the CNBC Web site] Why don’t they have media classes for rookie Fed governors and Treasury secretaries? Even if he’s got the FOMC position correct, typically the Fed governors come out with a consistent message, and then, they cloak and hedge opinions, in order not to jolt the markets.

Okay, so Fisher dissented.? So he hasn’t had a predictable tone since becoming a Fed Governor.? Big deal.? The Fed needs more disagreement, and more original thought generally, even if it is wrong original thought, just to challenge the prevailing orthodoxy, and force them to think through what are complex decisions that might have unpredictable second order effects.

2) I hate the phrase “ahead of (behind) the curve,” because there is nothing all that clear about where the curve is.

3) Watch the yield curve, and note the widening today.? That is a trend that should persist, regardless of FOMC policy.

4) Rate cutting begets more cutting, for now.? The current cuts will not solve systemic risk problems embedded in residential real estate, and CDOs, anytime soon.? They will help inflate China (via their crawling dollar peg), and healthy areas of the US economy.

5) Where is the logical bottom here?? How much below CPI inflation is the Fed willing to reduce rates before they have to stop, much less raise rates to reduce inflation?? My guess: they will err on lowering rates too far, and then will be dragged kicking and screaming to a rate rise, as inflation runs away from them.? The oversupply in residential housing will cause housing prices to lag behind the price rises in the remainder of the economy.

6) Eventually the FOMC will resist Fed funds futures, but for now, the Fed continues to obey the futures market.

7) The stock market loves FOMC cuts in the short run, but has not honored them in the intermediate-term.

Time to Begin Increasing Credit Risk Exposure

Posted on 31 January 2008 by David Merkel

Ugh, today was a busy day.? My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.? The bond market direction I got right.

Look at this post from Bespoke.? Ignore the percentage increase, and just look at the raw spread levels.? Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.? When you get to 10% yields, the odds tip in your favor on high yield.? That said, today’s crop of high yield corporate debt is lower rated than in the past.? Don’t go hog wild here, but begin to take a little more risk.? I was pretty minimal in terms of credit risk exposure for the last three years, owning only a? few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

For which of the following risks am I being adequately rewarded?? Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
What are my client’s tax needs?
How much volatility is my client willing to tolerate?
How unconventional can I be without losing him as a client?
What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.? That is where I have been for the past three years, and now it is time to adjust that position.? With respect to the list of risks:

Illiquidity: indeterminate, depends on the situation
Credit/Equity: begin adding, but keep some powder dry
Negative Convexity: attractive to add to prime RMBS positions at present.
Duration: Avoid.? Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
Sovereign Risks: Avoid.? You’re not getting paid for it here.
Complexity/Taint:? Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
FX: Neutral.? Maintain core positions in the Swiss Franc and the Yen for now.? Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.? The biggest changes are on credit risk and FX.? That’s a big shift for me.? If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.? Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.? I’m not trying to catch small moves.? Instead, I want to average into troughs before they hit bottom.? If you wait for the bottom, there will not be enough liquidity to implement the change in view.