Fed Funds Rate Has To Climb To 6%, Then Fall

Finally markets are coming to our long-held view: Fed Funds have to climb to around 6%. We put this view forth in June 2004, way ahead of the market. The markets remained in denial until last week, when they finally accepted reality - and sold bonds. But how does one make money off this?

What is driving inflation?

• It's not demand! As we discuss below, demand is slowing. Core inflation, the rate that the Fed observes, peaked more recently last August at an annual rate of 2.1%. By this April, that rate had halved, to 1.2%!
• Instead of demand - pull inflation, we keep warning of cost - push inflation: productivity is rising at a mere 0.7% per year, while wages are rising 6x faster, at 4.3%, so unit labour costs are rising by 2.2%.

Implications for profits

• They have to keep falling: higher unit labour costs cannot get passed on, so margins suffer

o Profits growth peaked at an annual 37% in March 2005; by this March, they had slowed down by 80%, to an annual rate of 6%!
o One reason for slower profits growth is higher unit labor costs: corporates cannot pass them on as readily for two reasons:

- first, overall demand is slowing. Retail sales peaked at an annual 9% in May 2006, and a year later were growing at about 5%: the consumer won't "take" higher prices, and
- secondly, if corporates were to pass their higher unit labor costs on, the Fed would whack them with another rate increase, further stomping on turnover

o Thus, profits have to worsen.

How to save money off this idea

• If it is true that profits ultimately drive stock prices, then our suggestion that The Economic Time™ is worsening in America suggests that you want to exit the stock market.

How to make money off this idea

• Buy into bond weakness. It is fair to say that on a one year view, Fed Funds will have peaked and will start their descent: Fed Funds rarely have "got stuck" at a high rate - at the outside, for about five months.
• When Fed Funds fall, so do bond yields. That is because people want to lock into the higher rates provided by bonds, so they buy high yielding bonds, driving down their prices. So up go the yields.

Comments

[nlipner:]

Sir, did you perhaps make a typo in this statement ?

• When Fed Funds fall, so do bond yields. That is because people want to lock into the higher rates provided by bonds, so they buy high yielding bonds, driving down their prices. So up go the yields.

More demand for the bonds should increase their price and reduce the yield, not the opposite as you stated. Correct ?

2007 Jun 15 12:17 PM

[Richie:]

"• Buy into bond weakness. It is fair to say that on a one year view, Fed Funds will have peaked and will start their descent: Fed Funds rarely have "got stuck" at a high rate - at the outside, for about five months."
"• When Fed Funds fall, so do bond yields. That is because people want to lock into the higher rates provided by bonds, so they buy high yielding bonds, driving down their prices. So up go the yields."

What the heck are you talking about ??? What do L/T bonds have to do with Fed Funds. ie, Where is there a direct connection between the two ???

2007 Jun 15 04:47 PM