The Liesman Indicator September 28, 2010, David Kotok, Chairman and Chief Investment Officer
Steve Liesman is one smart fellow. We knew that 10 years ago when he was still writing for the Wall St. Journal and before he subordinated his superb pen to national TV journalism.
As many readers know from watching CNBC, Steve has launched a new survey. It attempts to capture forecast changes among financial and economic professionals. Let us rightfully name it the Liesman indicator. It seems appropriate to give some credit to Steve’s able executive producer, Alex Crippen, who was helpful to Steve in the compilation.
Among the 67 respondents to Steve’s survey, we were one of the 70% who thought QE2 was definitely in our future. We thank Steve and Alex for the opportunity to participate. They plan another survey in the next few weeks to update and track QE expectations. The first round of findings was reported extensively on CNBC and discussed on the CNBC website.
The importance of this survey should not be underestimated. The Fed has driven interest rates to between 0.0% and 0.25% for policymaking purposes. The Fed has also expanded its balance sheet in an unprecedented way. Moreover, the financial press is rife with speculation about another Fed balance-sheet adjustment. See Jon Hilsenrath’s reporting in the WSJ to keep current on this subject. The Liesman indicator is a real-time way to track the changes in expectations of some skilled “Fed-watchers” in order to see how they are interpreting the Fed’s “open mouth” comments and “open market” policy implementation.
It also is an indirect way to track the surveyed professionals’ views about the strength or weakness of the economic recovery and of inflation or deflation expectations. The Fed is focused on the real economy and stimulating recovery from the recession. With their traditional forecasting tools now distorted, the Fed and the private-sector professionals have larger margins for error in their forecasts. They are dealing with uncertainties of unprecedented amounts and complexities.
Let us explain why we assert this view. We must digress briefly to explain.
These surveyed professionals know that the expectations component of interest rates is a critical element and is very difficult to measure. With interest rates anchored near zero, expectations estimation is more important than ever. Interest rates cannot go below zero; thus, they are impaired as a tool for forecasting. In addition, the closer to zero those interest rates go, the more the traditional relationships are distorted, because of changes in velocity. Think about it this way. The only difference between a $10-million treasury bill and a briefcase filled with 100,000 one-hundred-dollar bills is the cost of the security guards to watch the briefcase vs. the efficiency of the electronic-transfer capability of the T-bill. At today’s low interest rates, the cash yield of zero and the T-bill yield are nearly the same. In circumstances like this, traditional velocity measures fail. Traditional forecasting methods tied to interest-rate components also fail. That is why Liesman’s indicator is so important.
OK, let us get back to the Liesman indicator. Most of the respondents believe the Fed will do something before yearend. Timing is uncertain, but more expect action in November than in any other month. The average of the Liesman indicator forecasts adds half a trillion dollars to the Fed’s balance sheet.
Our firm’s estimate extends into next year and calls for a trillion-dollar addition before it is completed. We, like others surveyed, believe the employment conditions in the US will continue to be weak for many more months, and that may trigger the next round of Fed action. We are not alone in that view.
The Liesman indicator has confirmation from a study done by BOM Capital Markets (September 20, 2010). They are measuring the impact of labor market reports on interest rates and finding that the importance is rising with time. They specifically measure the correlation of ten-year treasury yields with a four-week moving average of weekly reported initial unemployment claims. Like Liesman, they are looking for high-frequency indicators. They found the “10-year rate will decrease (increase) by 12.7bps, for every 10K increase (decrease) in initial jobless claims.”
Using the Liesman indicator and the BMO research together, we can link the employment outlook (through claims) to the expectations of Fed action from the Liesman survey. Several studies have attempted to measure the amount of interest-rate change that occurs for every $100 billion of Fed balance-sheet change. The range of estimates is from 3 to 7 basis points. Our preference is on the lower side, so we will use 3 as our reference. In other words, if the Fed moves the asset side of the balance sheet up by $100 billion, the markets will change the pricing of the 10-year treasury yield by 0.03% or 3 basis points. BMO’s estimates suggest a 93% probability that a 12-basis-point change will result from a sustained increase in weekly jobless claims of 10,000.
Thus, a 10,000 increase in the level of weekly claims for unemployment benefits implies an interest rate change equivalent to a $400-billion increase in the Fed’s securities holdings, if all else is equal. We do not know if this change in rates is due to the expectations component at work. Is the market anticipating the Fed’s action and moving the rate down before the Fed actually implements a policy change?
Now, of course, all else is never held equal. Many forces move treasury yields. Jobless claims are volatile. In addition, the Fed contends with many elements when making policy. All that said, Steve Liesman has created an important additional tool.
Cumberland continues to favor longer duration in bond accounts and spread product over treasuries. Our accounts continue to be fully invested in bond and stock markets. We anticipate the economic recovery will be tepid and the inflation rate very low and of continuing concern to the Fed. We believe that the Fed will take as many steps as necessary to avoid a Japan-style deflation. And, we add that uncertainty with any strategy or forecast is very high.
Many thanks to Steve Liesman and Alex Crippen for their effort to stimulate national discussion of this important issue. And thanks to BMO for some very insightful help. All errors in this commentary are mine.
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