Despite fiscal woes, muni bonds' appeal stays strong

The good news in the sell-off that has clipped California tax-free municipal bond prices over the last six weeks is that the market now should be harder to shock.

So for muni investors, the report Wednesday that Sacramento already may be facing a $21-billion budget gap over the current and next fiscal years was more a firecracker than a bomb.

After rallying sharply in August and September, the California muni market has given back some of those gains since early October. Amid a flood of new bond sales by the state investors have demanded higher yields, which in turn has pushed prices of existing bonds down.

California is back in the market this week with a $1.34-billion revenue bond offering from the Public Works Board to finance infrastructure projects. Yields on those bonds will be set today.

All in all, though, the damage to the market from the supply glut has been relatively modest, at least for muni mutual fund investors who have the benefit of wide diversification. Case in point: The per-share net asset value of the Franklin California Tax-Free Income fund, which holds $14.2 billion of state and local debt, was $6.90 on Wednesday, a drop of 4% from the 52-week high of $7.19 on Oct. 5.

That’s unfortunate for anyone who bought near the high, but year-to-date the fund’s total return (share price gain plus interest earned) still is a hefty 15.6%. And that’s even better than it looks, given that the interest earned is exempt from state and federal income tax.

The muni market nationwide has been suffering a bout of indigestion since September, driving yields higher. But nationally and in California the market has been stabilizing over the last week or so.

Despite the dire fiscal outlooks for many state and local governments, there are three main reasons to believe that the muni market is unlikely to fall off a cliff from here and wipe out all of its recovery from the worst of the credit crunch:

--- Big investors just don’t buy the idea that actual defaults by muni issuers in 2010 will match the doomsday predictions that are out there.

"There is going to be a lot of ‘headline’ risk in the market over the next 12 to 18 months," said Chris Sperry, co-manager of the Franklin California fund. But local governments of any size know, he said, that the decision to default would make it impossible to get the basic credit they need to function. The market clearly believes that the vast majority of politicians will get out the cleaver and hack expenses further, not bond payments.

--- Muni yields still are historically high versus yields on taxable bonds. A 10-year California state general obligation bond now yields about 4.55% tax-free, compared with 3.36% for a 10-year U.S. Treasury note that is federally taxable. Muni bond yields normally are below Treasury yields.

"In order for muni yields to get a whole lot [higher] you’re going to have to see the Treasury market sell off," said John Carbone, manager of the Vanguard California Long-Term Tax-Exempt bond fund. That could happen, of course, but it probably would require the backdrop of a robust economic recovery or an inflation surge -- neither of which seems likely in the near term.

--- Many muni investors figure that tax rates at the federal, state and local levels can only go up as governments struggle to close deficits. That would boost munis’ appeal for yield-hungry investors. "Munis are going to become more attractive from a pure income standpoint," Sperry said.

Yes, he’s talking his book. But raise your hand if you think taxes are more likely to go down than up.

-- Tom Petruno

The Fed's 'road map' to higher interest rates

The Federal Reserve made clear Wednesday that it isn’t planning to raise short-term interest rates soon.

But the central bank also got more specific about the conditions that would spur it to lift its key rate from the current zero-to-0.25% range.

Here’s how the critical paragraph in the Fed’s post-meeting statement reads:

"The Committee will maintain the target range for the federal funds rate at 0 to 0.25% and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The bolded type is what was added to that paragraph since the Fed’s last meeting on Sept. 23.

"In citing these three conditions, the Federal Reserve has provided a road map by which market participants can gauge with greater precision the evolution of monetary policy, in particular the exit strategy for the Fed’s current stance," Tony Crescenzi, a bond market strategist at Pimco in Newport Beach, wrote in a note to clients.

"This will make the implementation of the Fed’s exit strategy more a process than event," Crescenzi said. "It will also give the Fed an ‘out’ because incoming data related to the three conditions mentioned will take on greater weight than the Fed’s own words, allowing the Fed to simply rubberstamp the conclusions drawn by market participants regarding the incoming data."

The first condition mentioned -- "resource utilization" -- could apply to both labor and factory capacity, both of which are severely underutilized at the moment. No debate there. Even if the economy keeps expanding, the Fed is saying that it wants to see labor and industrial slack taken up before it will think about tightening credit.

To measure whether inflation trends are "subdued," the Fed presumably would rely on the government’s major inflation gauges, including the consumer price index and the so-called personal consumption expenditures price index. The year-over-year gains in the "core" indexes of those gauges were 1.5% and 1.3%, respectively, in September, which in both cases would qualify as "subdued."

To measure whether inflation expectations are "stable," the Fed could look at future price increases implied by interest rates on Treasury inflation-protected bonds, and at trends in gold prices and the dollar.

Crescenzi noted that the Fed’s statement specifically referred to longer-term inflation expectations as being "stable" at the moment.

But are they?

"It is intriguing that the Fed would label inflation expectations ‘stable’ when the amount of inflation expectations embedded in 10-year inflation-protected Treasuries reached its highest point of the year -- 2.14%, indicating that 10-year inflation-protected Treasuries are priced for the consumer price index to increase at a 2.14% [annualized] rate over the next 10 years," Crescenzi said.

Gold, hitting record highs this week, also could be signaling rising inflation expectations. But gold’s new bull run also could be pointing to something more visceral -- increased distrust of all paper currencies -- rather than heightened concern about inflation.

-- Tom Petruno

Post-Fed scorecard: Gold at new high, other markets slide

Gold’s latest rally powered ahead Wednesday as the Federal Reserve maintained a dovish attitude toward interest rates.

Meanwhile, the dollar, the stock market and longer-term Treasury bonds all sold off after the Fed issued its post-meeting statement, which repeated that policymakers expected to keep short-term rates low "for an extended period."

Near-term gold futures gained $2.40 to $1,086.70 an ounce, a new record closing high that lifted the year-to-date price gain to about 23%. The metal traded as high as $1,098.50 for the day, after surging nearly $31 on Tuesday on word of the Indian central bank's big purchase.

Not surprisingly, the likelihood of the U.S. maintaining near-zero short-term interest rates was a negative for the dollar, which helped bolster the case for gold. The euro jumped to $1.487 from $1.472 on Tuesday.

The stock market, which rallied early in the day on some relatively upbeat economic data, surrendered most of its gains in the final 30 minutes of the session -- a decline some analysts blamed on the U.S. House’s vote to speed up new limits on credit card interest rates. That slammed bank stocks. The Dow industrials closed up 30.23 points, or 0.3%, to 9,802.14, after being up as much as 156 points.

Some investors also dumped longer-term Treasury bonds post-Fed. The 30-year T-bond yield jumped to 4.40%, up from 4.33% on Tuesday and the highest since Aug. 14.

On the face of it, the markets might seem to be worried about the Fed falling behind the curve in keeping inflation subdued -- except, where do you find inflation these days, other than in asset prices? (OK, oil is a problem again lately, that is true.)

Nicholas Colas, investment strategist at BNY ConvergEx Group in New York, thinks the stock market’s disappointing action is just another sign that "it’s definitely in need of a breather here." Stocks have been struggling since peaking in mid-October as more investors have turned cautious about the near-term economic outlook.

The Standard & Poor’s 500 index, which edged up 0.1% on Wednesday to 1,046.50, is down 4.7% from its one-year closing high of 1,097.91 on Oct. 19.

"The biggest single question is, how are consumers thinking about their prospects going into Christmas?" Colas said. People may think better about their prospects if they have more faith that job cuts are ebbing -- which is why the government’s report Friday on October employment trends will be key, as usual.

As for the sell-off in the bond market, traders noted that the Treasury on Wednesday gave more details about its plan to lengthen the average maturity of the government’s debt load, which of course means issuing more longer-term debt and fewer shorter-term securities. That may have triggered some knee-jerk selling of longer-term bonds.

As I noted in this post, the trend no one would want to see take hold this month (or any month) would be rising bond yields accompanied by falling stock prices. Just something to watch.

-- Tom Petruno

Photo credit: Genaro Molina / Los Angeles Times

Fed keeps 'extended period' pledge on low rates

Federal Reserve policymakers stayed with the status quo today, saying in their post-meeting statement that they expected to keep short-term interest rates low "for an extended period."

That had been the big mystery surrounding the Fed’s meeting -- whether Chairman Ben S. Bernanke and peers would feel compelled to signal that the improving economy would lead to tighter credit sooner rather than later.

By retaining the "extended period" pledge, the Fed is offering no incentive for markets to push up short-term rates on their own.

One change of note in the statement: The Fed will pare back on purchases of bonds issued by mortgage giants Fannie Mae and Freddie Mac, citing "the limited availability" of such debt. The change doesn’t affect the Fed’s larger purchase program of mortgage-backed securities, which is the direct way it is attempting to keep mortgage rates down.

Here is the text of today’s meeting statement, followed by the text of the statement from the Fed’s Sept. 23 meeting, for comparison:

Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period. Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt. In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010.

The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

The Sept. 23 meeting statement:

Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009.

The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

-- Tom Petruno

Buy gold at these prices? Two views

Gold, which hit a record high of $1,072 an ounce in mid-October, made a run at that level in Asian trading on Tuesday, reaching $1,066.90 an ounce before pulling back.

The metal had jumped $13.70 to $1,053.40 in New York trading on Monday as its bitter rival, the U.S. dollar, slipped after rallying on Friday. UPDATE at 10 a.m. PST: Gold has reached a new high of $1,085 an ounce in New York.

Would you buy gold at these prices, after nine straight years of gains? And if so, what’s your motivation? Inflation? Deflation? Fear of global pandemonium?

Two Wall Street figures now well-known for warning of the financial mayhem of a year ago -- hedge fund manager David Einhorn of Greenlight Capital, and New York University Economics Prof. Nouriel Roubini -- have two very different views of gold, at least in the near term.

Einhorn, who began buying the metal itself and shares of gold-mining firms after the financial crisis unfolded last year, said in a speech last month that he’s still big on gold as an insurance policy and as an alternative to major currencies and "cash" accounts.

From the speech (link from zerohedge.com):

"I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

"Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

"When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the 'stimulus' black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The euro, the yen, and the British pound might be worse.

"So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield."

By contrast, Roubini thinks that anyone expecting significant appreciation in gold soon from this point is dreaming.

From an interview Roubini gave last month with IndexUniverse.com:

"I don’t believe in gold. Gold can go up for only two reasons. [One is] inflation, and we are in a world where there are massive amounts of deflation because of a glut of capacity, and demand is weak, and there’s slack in the labor markets with unemployment peeking above 10% in all the advanced economies. So there’s no inflation, and there’s not going to be for the time being.

"The only other case in which gold can go higher with deflation is if you have Armageddon, if you have another depression. But we’ve avoided that tail risk as well. So all the gold bugs who say gold is going to go to $1,500, $2,000, they’re just speaking nonsense. Without inflation, or without a depression, there’s nowhere for gold to go. Yeah, it can go above $1,000, but it can’t move up 20-30% unless we end up in a world of inflation or another depression. I don’t see either of those being likely for the time being. Maybe three or four years from now, yes. But not anytime soon."

Who makes the more convincing argument?

-- Tom Petruno

Photo credit: Frantzesco Kangaris / Bloomberg News

Rates rise on inflation-adjusted U.S. savings bonds

The rebound in oil prices since March has had one beneficial side effect for savers: Interest rates will rise on Series I U.S. Savings Bonds, which earn returns adjusted for the inflation rate.

Series I bonds bought between Nov. 1 and May 1 will earn an annualized interest rate of 3.36% in their first six months, up from the zero earnings rate on newly issued bonds in the previous six months, the Treasury Department said today.

Series I bonds earn the combined total of their fixed annual rate, which is set for the 30-year life of the bonds, and the inflation rate as measured by the consumer price index. The inflation adjustment is recalculated every six months for new and outstanding bonds.

The new fixed rate on Series I bonds is 0.30%, an increase from the 0.10% fixed rate on bonds sold in the previous six months. So the government got a little more generous with the part of the return that it controls.

The inflation component will provide an annualized return of 3.06% on new I-bonds in their first six months after issuance, as well as on previously issued bonds as they adjust. Add the 0.30% fixed rate to 3.06% to get the total return of 3.36% on newly issued securities.

The surge in oil prices since mid-February pulled the consumer price index higher through Sept. 30. By contrast, plummeting oil prices had helped drive the CPI down in the six months through March. With the CPI negative for that period, Series I bond returns when adjusted May 1 paid no inflation adjustment -- the first time that had happened for any six-month period since I bonds were launched in 1998.

Still, I-bond investors are guaranteed that their returns can never fall below zero, even if the CPI were to decline again.

I bonds were far more attractive a decade ago, when the Treasury was offering fixed rates as high as 3.6%. Even so, if you think inflation will revive in the next few years thanks to the government’s massive effort to reflate the economy, I bonds still would offer a way to preserve your purchasing power by rising in line with the CPI.

Owners of previously issued I bonds can see their new earnings rates in a chart provided on savings-bond-advisor.com.

Also today, the Treasury said Series EE bonds issued in the next six months will earn 1.2% a year for the life of the security, up from 0.70% on EE bonds issued in the previous six months.

-- Tom Petruno

 

He foresaw the mortgage mess; now, he sees an inflation wreck

Investors who are convinced that serious inflation looms -- but who’ve been putting off buying gold or some other potential hedge -- will want to read the latest client letter from Kyle Bass, the hedge fund manager who made a fortune betting against mortgage-backed securities in 2007.

Count him as convinced about inflation, too, even in the face of the deflationary forces now bearing down on the economy.

Bass, who heads Hayman Advisors in Dallas, writes:

Western democracies, communistic capitalists and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero).

Get out the wheelbarrows!

Bass’ March client letter carried a warning about looming inflation, too. But back then, he declared the U.S. to be "in relatively better shape than the rest of the world," and thought that the dollar would be "a safer currency than any other."

The dollar, however, has been dropping since then, a downtrend that made headlines again on Tuesday.

In the latest letter, Bass seems much more concerned about the U.S.:

There have been 28 episodes of hyperinflation in national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz, professor emeritus of economics . . . at the University of Basel, has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, "Monetary Regimes and Inflation: History, Economic and Political Relationships," Bernholz analyzes the 12 largest episodes of hyperinflation -- all of which were caused by financing huge public deficits through monetary creation. His conclusion: The tipping point for hyperinflation occurs when the government’s deficit exceeds 40% of its expenditures.

Uh-oh. Office of Management and Budget projections, Bass says, "imply that the U.S. will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. One has to ask whether the U.S. reached the critical tipping point? . . . In fact, the recent price action in metals, the dollar and commodities suggests that the market is already anticipating the future."

But maybe the dollar still has a chance to be the best of a bad bunch: Bass goes on at length in the latest letter about the extreme risks that China and Japan face given their own free-money economic policies.

Where is Bass’ money now? Once short mortgage securities, he now has 50% of his portfolio in them, lured by the plunge in prices. He also has been buying what he believes is bargain-priced corporate debt.

And, given his inflation outlook, Bass says he owns precious metals, though he doesn’t say which ones or in what form.

-- Tom Petruno

Gold hits record high as dollar sinks and inflation fears revive

The New Gold Rush is on.

The metal soared to record highs early today, fueled by fresh fears that the dollar's status as the world's preeminent currency will continue to erode.

Gold futures in New York were trading at nearly $1,043 an ounce at about 8:15 a.m. PDT, up from $1,016 on Monday and topping the previous peak of $1,033.90 set in March 2008.

The dollar, which has been drifting lower for most of this year against other major currencies, took another hit today after Britain's Independent newspaper said secret talks were taking place among Arab states, China, Russia and other countries to stop pricing oil in dollars, and shift instead to a basket of currencies including the euro, the yen and the Chinese yuan.

Bloomberg News reported that Saudi Arabian Central Bank Governor Muhammad al-Jasser said his nation hasn’t held meetings with other oil producers or consumers on shifting away from the dollar, but that hasn't been much comfort to the buck today.

The euro rose to $1.475 from $1.466 on Monday. The yen strengthened to 89.01 to the dollar, from 89.51.

The dollar also came under pressure after Australia's central bank raised its benchmark short-term interest rate -- another sign of global economic recovery. To gold investors, that means a higher likelihood of rising inflation ahead.

The weakness of the dollar, and the risks posed to the greenback's status as the world's reserve currency, have been the biggest motivators for gold's fans this year.

But some analysts say gold's ascent reflects increasing doubt about the value of all paper currencies, as the world's central banks have pumped enormous sums of money into the financial system to rescue the economy after the U.S.-led crash.

“Gold is acting like the ultimate currency,” Chip Hanlon, president of Delta Global Advisors Inc. in Huntington Beach, noted on Bloomberg. “Central banks are following the same monetary course and trying to stimulate and inflate their way back to growth. Everyone’s concerned about the dollar, but it’s not like you can hate the dollar and fall in love with the euro or the yen.”

“Gold is not just seen as an inflation hedge here in the U.S. but is rather acting as a hedge against all currencies,” Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York, noted on Bloomberg.

-- Tom Petruno

Photo credit: Kim Jae-Hwan / AFP/Getty Images

Deflation warning? Treasury bond yields plunge amid new rush for safety

Money is pouring into Treasury bonds today, driving yields sharply lower as investors start the fourth quarter with another rush into what they perceive to be safe.

The yield on the 10-year T-note plummeted to 3.20% by about 12:20 p.m. PDT, down from 3.30% on Wednesday and the lowest since May.

The 30-year T-bond yield, charted below, has slumped below 4%, to 3.97% from 4.04% on Wednesday.

Falling market yields mean bond prices are rising. That should give a big boost today to the most popular bond mutual fund, Pimco Total Return, which has been loading up on long-term Treasuries in recent weeks, as detailed by portfolio manager Bill Gross.

The latest bond-buying binge is making individual investors look like they were ahead of the curve: The public has been voracious for bond mutual funds for the last few months even as many Wall Street bulls insisted that stocks were the smarter investment in a recovering economy.

Today, stocks are selling off amid fresh concerns about the economy’s ability to sustain a recovery, despite the surprising rise in consumer spending in August. The Dow Jones industrial average was down about 150 points, or 1.5%, to 9,564 at about 12:20 p.m. PDT.

For the bond market -- or at least, high-quality bonds such as Treasuries -- the explosion in demand today suggests an epiphany for many investors who’ve been disbelieving that long-term interest rates could go much lower.

Many bond pros say weakness in key economic data in recent days (including today’s report on U.S. manufacturing activity in September) has raised strong doubts about the recovery.

More investors are sensing that "the feel-good bounce in the economy created by the [government’s] fiscal stimulus is not a permanent factor," said Tom Tucci, head of Treasury trading at RBC Capital Markets in New York.

That boosts the likelihood that the Federal Reserve will have to maintain near-zero short-term interest rates well into 2010, he said. And if short-term rates aren’t heading higher, investors are more comfortable locking in current yields on longer-term bonds.

Rising tensions between Iran and the West also are encouraging investors to find refuge in the traditional haven of Treasuries, said Tom Di Galoma, head of U.S. rates trading at Guggenheim Capital Markets in New York.

But the biggest factor driving cash into longer-term bonds is the feeling that there is no inflation threat to fixed-income securities, Tucci and Di Galoma said.

In fact, sentiment is shifting more toward the idea that the U.S. could face outright deflation, Tucci said.

Figure it this way: If inflation is 2% and a bond pays 3% interest, the "real" or after-inflation yield is just 1%.

But say inflation turns to deflation, and the U.S. sees broad-based declines in prices of goods and services, similar to Japan’s experience.

At a deflation rate of 2%, the real return on a 3% bond would be 5% -- a huge number, by bond standards.

The deflationistas are still a minority camp on Wall Street. But their numbers will grow if the economic data get weaker instead of stronger.

A big test looms for the bond rally on Friday, with the government’s report on September employment. Wall Street expects that the economy lost a net 175,000 jobs last month. If the tally is larger than that it could spark another rush out of stocks and into Treasuries.

-- Tom Petruno

Fed's new mantra: Tighter credit is coming, but not soon

Another day, and another Federal Reserve official warning us that the central bank will someday have to take away the enormous wad of cheap money it has provided to the financial system and the economy.

Just not soon.

Fed Vice Chairman Don Kohn, speaking in Washington at the Cato Institute, spent most of his time addressing the inevitability of tighter credit down the road.

"We will need to begin to remove the extraordinary degree of accommodation in its various dimensions when we judge that exiting from the current stance of policy will be necessary to preserve price stability as the economy returns to higher levels of resource utilization," Kohn said.

Translation: When the Fed starts sensing that inflation pressures are building because people and businesses are spending again, it will be time to make easy money much less easy.

No shocker there. And repeating the theme of other Fed officials in recent days (e.g., Kevin Warsh), Kohn warned that the central bank will have to be preemptive: It will act before the public may believe that tighter credit is warranted.

"Because it takes people time to adjust their spending and pricing decisions in response to a change in interest rates or other aspects of financial conditions, like other monetary policy decisions, [the Fed’s] judgment will need to be based on a forecast of economic developments, not on current conditions," Kohn said.

That’s also why the Fed is likely to keep talking about its easy-money "exit strategy" ad nauseam, Kohn suggested.

"The unusual nature of our actions and the uncertainty about when and how they will be unwound suggest an even greater payoff than usual from being as clear as possible in our communications with the public," he said.

But he ended his speech by stressing that the Fed is in no hurry to tighten credit -- which Wall Street, of course, takes as an article of faith, and probably more so after today's surprisingly weak economic data.

"Although economic conditions have apparently begun to improve -- partly in response to the extraordinary steps the Federal Reserve and other authorities have taken -- resource utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to constrain the speed of recovery," Kohn said.

"For that reason, as the [Fed] stated last week, exceptionally low interest rates are likely to be warranted for an extended period," he said.

Fed Bank of Atlanta President Dennis Lockhart, speaking in Alabama, used even stronger language about the need for policymakers to be patient.

"I do not think that time has yet come, and to be consistent with my outlook, I think it may well be some time before [a] comprehensive exit need be underway," he said.

-- Tom Petruno

Photo: Fed Vice Chairman Don Kohn. Credit: Susan Walsh / Associated Press