Bernanke Preview

Given the heightened uncertainty about the near-term outlook for US monetary policy, this week’s semi-annual congressional testimony by the Federal Reserve Chairman will be closely scrutinized for clues. Federal Reserve Chairman Ben Bernanke’s semi-annual testimony before Congress this week is looked.

The risk is that the market is disappointed. Fed officials have gone to pains to emphasize that policy is data dependent. There simply has not been much in way of critical economic data since the June 29 FOMC and the accompanying statement. The ISM survey data was consistent with the moderation in activity and stabilization in prices. The June employment data was mixed.

What was disappointing non-farm payroll growth for the market was within the ranges consistent with trend growth. The 0.5% rise in hourly earnings on the surface might be disturbing, but there are two mitigating considerations. First, earnings data in the abstract like that means little from a policy making point of view in the absence of measures of productivity. Therefore, unit labor costs are a more important measure and appear contained. Second, the hefty profit margins being reaped by Corporate America, even if not being rewarded by equity investors, offer a significant buffer between earnings and inflation. Some measures of inflation expectations have eased slightly, as picked up by the University of Michigan’s survey and the pricing of US inflation-protected securities.

Despite eschewing Greenspan’s strategic ambiguity, Bernanke will be hard pressed to tip his hand because frankly there are few cards in it at the moment. With a 13% rise in the p[rice of oil since mid-June, and other measures of price pressures above what officials themselves regards as a “comfort zone”, Bernanke will rightly be concerned about the risks of inflation. Within what appears to be tantamount to a tightening bias, Bernanke will likely continue to prepare the markets for a pause at some juncture, but it is unreasonable to expect him provide much details as to the timing.

As a student of the Fed, Bernanke, like others, are well aware of the argument that the central bank often raises rates too much. Given the unpredictable lag and lead times of monetary policy, a pause should be understood as insurance against an overshoot. Throughout the monetary cycle, many market participants have had to be brought kicking and screaming to appreciate the magnitude and duration of the Fed’s tightening. However, one view that has remained fairly stable this year is the expectation that by this time next year, the Fed will to contemplating a rate cut. The yield implied by the Sept 07 Eurodollar futures contract has been trading between 10 and 20 basis points below the rate implied by the Sept 06 Eurodollar futures contract. Typically, assuming a steady Fed policy, one would expect a small term pick-up.

Looking at the August Fed funds futures contract, a pause at the August FOMC meeting would mean that fair value is 94.75 (5.25% implied yield). If the Fed hikes 25 bp, fair value would be 94.565 (5.435% implied yield). The latter is arrived at by assuming Fed funds reach the target of 5.25% on average for the first 8 days of the month and then 5.50% for the remaining 23 days. We divide the sum (168.5) by 31 to arrive at the average daily rate of 5.435%. The contract currently yields 5.38%. This means that 13 of a possible 18.5 points (the difference between 5.25% and 5.435%) has been discounted or the market is pricing in about a 70% chance a hike (13/18.5).

If our analysis is correct and Bernanke does not offer the market any more guidance that was provided by the FOMC statement following its recent rate hike, then we suspect the market will not be as confident of a hike at the end of the week as it is today. Given the recent run-up in the US dollar, the greenback may be vulnerable as well to a downgrade of the odds of a Fed hike back to a more neutral 50/50 chance.