Interest Rate Comments

Of late, Fedspeak has been hawkish on inflation and has spoken
fondly of the US Dollar. Itchy trigger fingers? Well, inflation has
exceeded the Fed's expectations, and the economy has not yet
developed the deeper weakness the Fed has feared.

For example, take the ISM survey of manufacturing. This broad
diffusion index made an expansion cycle low of 48.3 for 3/o8. A
reading below 50 on this index signifies contraction, but it
usually needs to fall below 43.5 and stay down for awhile before
recession is confirmed. Importantly, it is rare for the Fed to
elect to raise short rates before a recovering ISM index breaches
54 on the way up. If the Fed stays true to its longer term behavoir,
the ISM index (now 49.6) and other critical data such as the capacity
utilization rate would suggest a FFR% increase could be down the road
some, especially since it is not clear that the economy has bottomed.

The entire Treasury yield spectrum has risen since the March
shotgun marriage of Bear Stearns / JP Morgan Chase. The 91 day
T-bill yield has moved up sharply from a panic low of 0.5% to nearly
2%, or in line with the Fed Funds Rate. Comparably, the 30 year
Treasury has jumped from 4.11% to around 4.80%.

Quality spreads at the short end remain quite elevated and are in
line with recession levels. So too at the long end. The panic in the
wake of the subprime bust may be over, but most players are
indeed conservative and are not yet avidly chasing yield.

The Treasury market is too low in yield relative to the inflation
rate. A 2% bill is a loser compared to the recent 4% yr/yr CPI
readings, and the bond market puts you out over 20 years just to
earn modest amounts in real terms. You have to assume that the
big money which needs to own Treasuries to match liabilities (such
as retirement funds) is hedging with oil or gold or other commodities.
So too, foreign players may also have been carrying long
euro positions on top of inflation hedges.

To wrap up, I have long found it tiresome to try to psyche out the
Fed. It is understandable with the run up in oil et al that They
would like to get back to spotlighting inflation. But well observed
history says that action to match this new yearning is premature.