Mid-Year Review

Yes folks, it is that time of the year. It is the time of the year for me to take a holiday. For the following two weeks, Making Sense will be conspicuously absent from you inbox. Fear not, I will be back on July 11th.



But before I go, we would like to recap the first half of 2011. Here goes:



The recovery was sluggish; the natural disasters in Japan, the sovereign debt crisis in Europe, a declining housing market and poor job growth conspired to send long-term interest rates lower. This was especially true following the Fed's decision to end QE2 purchases at the end of June, but to continue to reinvest maturing assets.



The Fed's decisions to end QE2 bond purchases sent the blogosphere into a tizzy with predictions of spiking interest rates due to a lack of demand for U.S. treasuries once the Fed ceased purchasing U.S debt. Surprise! Rates went in the other direction as most of the alarmists (few of whom were actually fixed income market participants) failed to understand that the cessation of QE2 was potentially disinflationary (think quantitative tightening).


What does the second half of the year hold in store? The consensus forecast among Wall Street economists calls for sluggish economic growth. Headline CPI (including food and energy) is forecast to run at an annual rate of 3.00% for 2011 before falling to 2.20% for 2012. If this forecast is anywhere close to reality there should only be modest pressure on long-term interest rates and almost no change to short-term rates, such as Fed Funds and Three-Month LIBOR. In fact, it is not inconceivable that the Fed keeps Fed Funds unchanged throughout all of 2012.

This is not to say that there will be no Fed tightening. Should the Fed cease reinvesting its maturing QE assets or begins to sell them, that would be a form of (quantitative) tightening. The Fed could, in theory, sell its QE assets and effectively raise policy rates approximately 100 basis points without touching the Fed Funds rate (see Taylor Rule).

Don't look for consumers to ride to the rescue. They are deleveraging and will continue to do so. Gone are the days of easy credit and a new SUV every two years. This is a healthy, but painful development.

See ya in two weeks.