Pyrrhic Victory
John Mauldin's Outside the Box

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Readers know that Paul McCulley of Pimco, and his cohort Bill Gross, are two of my must read economic analysts. Pimco is in Newport Beach California and oversee more than $400 Billion in assets, predominately in fixed income.

This is Paul McCulley's August 2005 Fed Focus letter. Several weeks ago I talked about Greenspan's remarks that the Fed was targeting asset prices. There is nothing more he would like to see than the ten-year bond yield rise, but to this point it has been flat or down. McCulley looks at why the ten-year yield has not gone up, in what he calls the "Greenspan Put" and why an inverted yield curve may be in our future. That is why this was picked for this week's Outside the Box.

- John Mauldin

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Pyrrhic Victory

Friday, July 1, was a barbelled day for me: pain in the morning but fun in the evening. I needed to be in New York that evening to appear on the premiere of Consuelo Mack's new show, WealthTrack, on PBS. Modeled on Lou Rukeyser's Wall Street Week, and indeed, appearing in his famous Friday night time slot, it was going to be (and was!) an august moment, celebrating Consuelo's new venture and connecting up with good friend Ed Hyman, the star guest.

But I couldn't fly out that day and get there on time. I also couldn't fly out the prior day, because it was an FOMC day and as a matter of policy (mine, not PIMCO's), I do not like to be away from my trading station here in Newport Beach on FOMC days, except for strategic client requests. And, as much as I adore Consuelo and her awesome hubby, Walter, they aren't strategic PIMCO clients. So, I did the obvious thing and took the redeye out Thursday night, arriving in New York early Friday morning. Nothing unusual about that, as all of us working on Wall Street on the left coast routinely make this nocturnal sojourn; our bodies are used to it.

Much more important than losing a night's sleep was news to be released on Friday morning that was actually more important, at least to me, than the FOMC announcement the prior day: the Institute of Supply Management Index, commonly known the ISM Index, for June. This was the source of pain on that barbelled day.

A Rendezvous That Didn't Rendezvous

As regular readers know, I put a lot of importance on ISM data in my work as both a member of PIMCO's Investment Committee and as a portfolio manager. In fact, I have featured the ISM Index twice in the last four months on these Fed Focus pages. In May1, I pounded the table that when the Index fell below 50 -- which stood at 53.3 in April, down from a peak of 62.8 in February 2004 -- the Fed would be finished with its on-going tightening campaign, as the Fed had never, during the Greenspan era, tightened with the ISM Index below 50. I further forecasted such a drop below 50 was "virtually certain" in the months immediately ahead.

I looked right when the ISM Index fell still further in May to 51.4, as announced on the first business day of June. And indeed, during June, the market had a full blown romance with my scenario of a near-by end to Fed tightening: just one more month of trend decline in the ISM Index and it would dip below 50! Would it be for June? That was the question when I got off the redeye in New York on Friday morning, July 1, with the ISM Index for June slated for release at 10:00 am.

In the event, the ISM reported a bounce for its Index to 53.8 for June. Sitting in my hotel room, I immediately fired off an email to my Investment Committee partners, declaring:
"The market is obviously going to put in a risk premium that we are wrong about the 3½% Fed funds rate stopping point. Doesn't mean we are wrong, I hasten to add, but that is irrelevant when it comes to the market's real-time romancing and discounting and risk-premium setting."
It was one of those days you know, just know, you will remember for a long, long time. The one thing virtually certain to stop the Fed in its tightening tracks did not happen: the ISM Index, which I had declared two months earlier to be on a "virtually certain" rendezvous south of 50, had no such rendezvous. Thus, I knew, and the market knew, that the Fed had just been given a license to continue tightening beyond 3½% Fed funds, if that was its wont. Which it was, as confirmed twenty days later by Mr. Greenspan before Congress, when presenting the Fed's semi-annual policy report.

Policy was still "accommodative" he declared, saying the Fed would continue to remove said accommodation at a "measured pace." All in the pursuit of something called policy "neutrality", of course, which he resolutely refused to define, simply declaring once again that he would know it when he saw it, perhaps after he had overshot it.

The FOMC backed up Mr. Greenspan's words on August 9, taking another 25 basis-point "measured" step to 3½% Fed funds, while reiterating that, yes, policy was still "accommodative," with said accommodation to be removed at, yes, a "measured" pace. But none of that was a surprise, as the ISM Index had foretold it all back on July 1, when it "failed" to plumb a trough below 50.

free dumb

'tis often said that the truth will set you free
but for the fomc
freedom is just another word
for a free pass to play dumb
as they fight lenders
lending for free to the dumb
who anticipate still dumber
to take them out of roofs
never intended to shelter from the rain
but to relieve the pain
of saving from paychecks
un-fattened by productivity gains
flowing freely to fattened corporate profit gains
which the fomc seeks to protect
all in the interest of defeating a cost-plus inflationary model
which has already been defeated by globalization
while giving birth to conundrums
which really aren't conundrums
unless you seek freedom
to target property prices
while singing bye to my
and let's all share the pie
while denying labor its fair slice
because you believe
the invisible hand works
only for the rich list
who owns the fist
to draft a larger reserve army of the unemployed
all in a nairu mist
to obscure
popping of bubbles
that aren't really bubbles
unless they prove their existence by blowing up
at which time
granting free dumb to inflate new bubbles
proving the fomc's ability
to walk on water
as they are the chosen
to decide
who will be cold
and who will be frozen.

By Paul McCulley,
written August 9, the day of the most
recent FOMC meeting.

Stealthily Targeting Asset Prices

So, does the Fed now have license to tighten until the last dog dies? I think not, even as I also think the Fed would like we the markets to presume such a scenario. Why? What the Fed wants most right now, in my view, is a bear market in intermediate and long-term bond prices, so as to undermine the on-going bull market in property prices. Mr. Greenspan hasn't put it exactly that way, of course, waxing on and on about his conundrum, the putative "failure" of intermediate and long-dated bond prices to fall, lifting their yields, as the Fed has hiked the Fed funds rate 250 basis points.

But make no mistake, Mr. Greenspan is more than a little ticked off at both the level and term structure of market-determined interest rates: he would like the yield curve to be both higher and steeper, so as to deflate speculative fervor in property markets. Put more technically, he'd like the "term risk premium" embedded in the level and slope of the yield curve to be higher, inducing an immaculate correction in property prices, rather than a bear market bearing his name.

This ain't just me talking, but Greenspan himself on July 202 (my emphasis, not his):
"According to estimates prepared by the Federal Reserve Board staff, a significant portion of the sharp decline in the ten-year forward one-year rate over the past year appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty. Nevertheless, they suggest that risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets inferred from prices of stock and bond options and narrow credit risk premiums. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress.

Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor."
That's about as clear as Greenspan ever speaks! And while he would reject the proposition that he's targeting lower ten-year bond prices (higher ten-year bond yields) as a tool to break froth and speculative fervor in property markets, that is, in fact, precisely what he is targeting.

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Indeed, Mr. Greenspan saw his July 20th risk-premiums-are-too-low ante and upped himself today in Jackson Hole, declaring3:
"The lowered risk premiums - the apparent consequence of a long period of economic stability - coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk4. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."
Despite such hot rhetoric, the ten-year Treasury yield is (almost) exactly the same today as it was on July 20. Why does the ten-year continue to defy him? There are many hypotheses, with Ben Bernanke's thesis of a global glut of savings relative to intended investment (per Keynes!) remaining at the top of the list.

We here at PIMCO certainly share Mr. Bernanke's thesis, stressing its power in the context of Bretton Woods II exchange rate arrangements, which create a de facto monetary union between the USA and China and, more loosely, Asia and the (ex Eastern Europe) emerging country universe. Thus, as a "fundamental" matter, we anticipate that Mr. Greenspan will continue to be frustrated by "extremely low" ten-year Treasury yields.

Time Inconsistency and the Greenspan Put

In fact, I submit that Mr. Greenspan's "technically" upped the ante against himself today, when he officially declared that policy is becoming "increasingly driven by asset price changes." Let me walk you through the logic of why, using the economic thesis of "time inconsistency," which won the Nobel Price in Economics for Professors Kydland and Prescott.

Their elegant, but simple thesis was that expectations about future policy reversals can undermine the power of current policy. My favorite real world example is that of a parent who says to a teenager: get a job this summer and save some money, or you will be walking rather than me driving you to school in the fall.

If the teenager knows that the parent will, in fact, do the driving come fall, regardless of whether junior gets the summer job - because that's what happened last summer and fall - then the parent's policy is time inconsistent: if the teenager knows the summer policy will be reversed come fall, he will rationally ignore the summer policy of getting a job and instead go to the beach. The parent's policy is simply not credible.

Increasingly, it seems to me, the Fed's policy of threatening never-ending Fed funds hikes, as Mr. Greenspan implicitly did today, so as to induce lower bond prices (higher bond yields) that will "get at" frothy property markets suffers from time inconsistency. Bluntly put, the Fed has a credibility problem, because the markets know - because Mr. Greenspan has taught us! - that the Fed's asset price bubble policy is asymmetric:
  • Deny that you can see them when they are inflating, tightening against them only if you can justify tightening on the basis of conventional inflation-pressure models and data.
  • Ease vigorously and purposefully when bubbles confirm their existence by blowing up.
Yep, that's the Greenspan approach, elegantly described (and endorsed) today as a "mop up after" strategy by former Fed Vice Chairman Alan Blinder, speaking in Jackson Hole.5 The strategy has also been called the Greenspan Put (early on by both me6 and my partner Bill Gross).

Professor Blinder addressed this matter of the Put derisively today, noting that if such a Put was in force in 2000, it certainly didn't "pay off," as the Fed hiked the Fed funds rates twice in 2000, after the bubble stock market peaked.

In a narrow sense, Mr. Blinder is right: if Greenspan had "shorted" a Put on the stock market, it was out-of-the-money worthless! But in a broader sense, I submit that Mr. Blinder is wrong: Even if Mr. Greenspan didn't short the stock market a Put, he did short one to the default risk-free bond market: a promise to ease with force if the collapsing stock market triggered bad things in the real economy.

That Put "paid off" big time in 2001. And it paid off again in 2002-2003, when the Fed eased to 1% Fed funds, so as to preempt deflationary risks, which were rooted in a collapse of confidence in the corporate bond market, a lagging consequence of risk aversion borne of the bursting of the stock market bubble two years prior.

Don't get me wrong here! I have nothing but praise for the Fed's 2001-2003 easings; they were the right thing to do, as Professor Blinder also argues. That should not obscure the fact, however, that those easings "taught" the default risk-free bond market that tightening aimed (indirectly, of course!) at asset bubbles will be reversed, big time, if and when those bubbles pop.

This is the real Greenspan Put! And, I submit, it is a key reason - beyond the good fundamental reason of a global surplus of savings relative to intended investment - that the Fed will continue to be disappointed in its wish that falling bond prices (rising bond yields) "do its work" of cracking speculative froth in property markets.

It's a time inconsistency problem! Why should we in the bond market bearishly discount an ever-rising Fed funds rate, if an ever-rising Fed funds rate will surely burst property prices, begetting a reversal to vigorous easing?

Indeed, San Francisco Federal Reserve Bank President Janet Yellen explicitly made the case for just such a scenario two weeks ago, when she declared7:
"Wealth effects - positive or negative - tend to affect spending with fairly long lags. So, a drop in house prices probably would lead to a gradual cutback in spending, giving the Fed time to respond by lowering short-term interest rates and keeping the economy steady.

Now let's complicate things. Suppose house prices started falling because bond and mortgage interest rates started rising as the conundrum was resolved, say, because the risk premium in bonds rose due to concerns about federal budget deficits or other factors. Then we'd have the cutback in spending because of the wealth effect, plus there'd likely be further spending cutbacks, as borrowing costs for households rose. Furthermore, a rise in long-term rates would have effects beyond just households - it also would dampen business investment in capital goods through a higher cost of capital.

How manageable would this scenario be? Like the wealth effect, these added interest-rate effects operate with a lag, so, again, there probably would be time for monetary policy to respond by lowering short-term interest rates. This obviously would not be a 'slam dunk,' but in many circumstances it would seem manageable."
Just like the at-the-beach teenager, we the markets have learned to value our options, in this case, the Greenspan Put:
The higher the Fed takes the Fed funds rate, the greater is the probability and the nearer the timing of a hard landing for property prices and the economy and, therefore, the greater the probability and the nearer the timing of a reversal to easing. Thus, the more the Fed tightens, the lower will be the "term premium," which Mr. Greenspan says is the dominant cause (a "significant portion") of his conundrum.

To the Moon, Alan?

So, what's the Fed to do, facing a dilemma similar to the parent trying to figure out how to get the teenager off the beach into a job? Conceptually, and consistent with the consensus of bearish pundits, the Fed could simply hike short rates until the housing market cries uncle, accepting that such a course is likely to invert the yield curve. To wit, the Fed could resignedly accept that the longer end of the curve is not going to "do its work" and do the "heavy lifting" itself with more nasty short rate hikes. This is, indeed, a plausible scenario.

In fact, Mr. Greenspan rhetorically carved out the flexibility for the Fed to invert the curve in an exchange with Senator Shelby on July 20:
Senator Shelby: Would the Federal Open Market Committee continue raising the Federal funds rate even if the yield curve becomes inverted in the months ahead?

Chairman Greenspan: Well, first of all, I can't comment for the Federal Open Market Committee's actions in the future because we haven't taken them. And we will obviously engage in deliberations ongoing to make judgments at each of our meetings.

But I think there is a misconception relevant not to what we may do but to the importance of an inverted yield curve.

It is certainly the case that, if you go back historically, that an inverted yield curve has actually been a reasonably good measure of potential recession in front of us. The quality of that signal has been declining in the last decade, in fact, quite measurably.

And the reason, basically, is that it was a good measure in the early period when banks, commercial banks, were the major financial intermediaries. And when you had long-term interest rates rise - I should say, short-term interest rates rise relative to long-term interest rates - it usually implied a squeeze on the profitability of commercial banks because they tend to hold somewhat longer maturities on the asset side of the balance sheet than on the liability side.

And as a consequence of that, that squeeze was usually associated with an economy running into some trouble.

But we have had extraordinary new avenues of financial intermediation developed over the last decade and a half. And therefore, there are innumerable other ways in which savings can move into investment without going through the commercial banks.

And as a result, a straightforward statistical analysis of the efficacy of the issue of yield inversion as a forward tool - I should say that the evidence very clearly indicates that its efficacy as a forecasting tool has diminished very dramatically because of economic events.

So, yes, we do look at the structure of long-term rates and the inversion of yields, as well as a whole panoply of everything else before we make judgments as to what we do with the Federal funds rate.

Our basic goal, as I've indicated many times here, is essentially to create an environment which sustains maximum sustainable growth. And we've always argued, because the data are so persuasive, that inflation stability is a necessary condition to achieve that goal.

In that context, we make our judgments meeting by meeting.

Senator Shelby: But is the possibility of an inverted yield curve still relevant to your thinking along with other factors?

Chairman Greenspan: Yes, it is. And because even though its forecasting or anticipatory capability is greatly diminished, it's not zero.
Mr. Greenspan is surely right - and for the right economic reasons! - that an inverted yield might not imply a recession, as it universally has in the past. Yes, this time might be different! But it might not be, either. Thus, for the Fed to defy the risk management lesson of history - don't invert the curve unless you want to underwrite the odds-on risk of recession - would be a hugely bold decision. Is the Fed willing to make it?

I don't think so. In fact, I think there is more than a sporting chance that this whole issue becomes moot, as "speculative fervor" in property markets exhausts itself from its own exuberance. But I wish I could say that with greater confidence. What I do feel highly confident about is that if the Fed does attempt to bearishly invert the curve a little, the market will subsequently respond by bullishly inverting it a lot.
Put more technically, the value of the Greenspan Put will rise exponentially if the curve inverts, while the cost of "buying" that Put will actually become negative: in an inverted curve, a duration-equal barbell of cash and long bonds yields more than a bulleted portfolio. Such is the weirdness of an inverted curve: the less volatile, convex barbell structure actually yields more than the more volatile, less convex bullet. Rather than paying for insurance, you get paid for taking it!

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Bottom Line

I was wrong in anticipating a trough below 50 for the ISM this summer, stopping the Fed in its tightening tracks. Facts are facts and that is a fact. But far more important than my bruised ego is the fact that ISM's "failure" to trough below 50 has given the Fed license to "go after" what Mr. Greenspan considers to be excessively high asset prices, the product of excessively low risk premiums.

Frothy regional property markets, fueled by speculative fervor, are Mr. Greenspan's most obvious candidates for a trip to the woodshed after supper. And the switch he'd like to use for the whipping is a higher risk premium in the term structure of the yield curve. But we the markets are unlikely to provide it to him, as we have learned the value of the Greenspan Put, in the context of the Nobel-winning concept of time inconsistency.

So, if Mr. Greenspan really wants to preemptively spank asset prices, he's going to have to take off his own belt of nasty tightening, which is likely to invert the yield curve. I doubt he's willing to do that and, in fact, suspect that he might just get lucky, with speculative froth in property markets exhausting itself of its own exuberance. But I wish I had more confidence in that suspicion. Investors in all risk assets - except, ironically, long-dated, default risk-free bonds - should consider themselves to have been warned.

Meanwhile, for investors with a philosophical bent, let me leave you with a rhetorical question:
If, as Mr. Greenspan said in January 19988, risk premiums are "lowest at price stability" and if, as Mr. Greenspan said today, that "history has not dealt kindly with the aftermath of protracted periods of low risk premiums," was the achievement of secular price stability a pyrrhic victory?

1 "Fundamentals In Technical Drag Are Still Fundamentals," Fed Focus, May 2005



4 Here at PIMCO, this "indirect result" is known as the journey, in contrast to the (present!) destination of simply rich assets with low prospective returns. This conceptual theme was at the core of my presentation to PIMCO's Secular Forum in May 1998, when I was Chief Economist for the Americas at UBS. I revisited the concept in the January 2000 Fed Focus, "In the Fullness of Time."


6 I attempted to put a value on the Greenspan Put in the February 2000 Fed Focus, "Me and Morgan le Fay", writing that without the Put, the P/E for the S+P 500 should be 18, not 32.


8 "If increases in both inflation and deflation raise risk premiums and retard growth, it follows that risk premiums are lowest at price stability. Furthermore, price stability, by reducing variation in uncertainty about the future, should also reduce variations in asset values." Alan Greenspan, January 3, 1998.


I hope you enjoyed today's Outside the Box. To find other commentary by Paul McCulley and the rest of the analysts at Pimco you can go to

Your watching the yield curve analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 09-12-2005 2:17 AM by John Mauldin