The Fed's Monetary Policy Dilemma
We have pointed out before that the year 2003 was unusual in the sense that every asset class including bonds, stocks, real estate, and commodities went up in price. Then, we had after February/March of this year all asset classes - except for real estate - declining in price and, now, since mid May, we have all asset classes including stocks, real estate and commodities, but excluding bonds and the US dollar, moving up in price again - this largely as a result of a massive monetary expansion engineered by Mr. Greenspan. I am mentioning this because it is for the American Federal Reserve possible to increase the money supply exponentially (in the last four weeks at an annual rate of more than 20%) and keep US interest rates significantly below the rate of inflation (see figure below). But by "printing" too much money the Fed pushes also the US dollar down and creates eventually higher inflation rates, which will one day in future also drive interest rates much higher.
In fact, whereas, as can be seen from the above figure, the Fed fund rate is currently at 1%, it should be today - based on nominal GDP growth and recent inflation - at least at 3% to 4% (fed watchers say the Fed is "way beyond the curve"). In fact, if you look at the spread between the T-Bill Rate and the 30-Year T-Bond Yield, the spread is at its widest level in the last 70 years (see figure below courtesy of Bridgewater Associates) indicating that short-term rates are far too low at this point of the business cycle, and also given the housing and energy price induced inflation we have at present.
Therefore, Mr. Greenspan has come to a dead end street with his monetary policy. Despite ultra easy monetary policies the bond market has tumbled since March of this year with the result that the housing refinancing index has also collapsed to the lowest level since May 2002. This by itself may have some negative implications for US consumption in the next few months, as refinancing activity allowed homeowners to withdraw equity from their homes, which was then largely spent on consumer goods and equity purchases (see figure below courtesy of Bridgewater Associates). In fact, it will be interesting to see whether the recent strong employment gains (at least statistically and superficially interpreted) will be able to offset lower home equity withdrawals by homeowners. My opinion is that this is unlikely to be the case, and that consumption will slow down in the next few months - also because financial market investors have failed so far this year to make any money and are already likely to sit on some losses, as they positioned themselves in asset inflation plays such as copper, steel, shipping and housing stocks, all of which are already down from their March highs by 30% or more.
Now, Mr. Greenspan has two options. Either he does pursue his policy of keeping short-term interest rates artificially low, or increases them in baby steps of just 0.25% increments and at a slow pace, or he takes some more drastic tightening moves action and increases short-term rates in 0.50% increments right away. In the first case, the bond market will continue to drift lower, as inflation will suddenly accelerate meaningfully and in the process also drive down the dollar. Alternatively, he drives interest rates up significantly, but then stocks, and home prices will ease and have a negative impact on consumption, while bond prices and the dollar should be in a position to rebound. In short, I am mentioning this because unlike what we experienced in 2003, when all asset classes including stocks, commodities, real estate and bonds rose in concert, we are beginning to see, in 2004, diverging performances of asset markets. Either bonds and the dollar will continue to tank while stocks, commodities and hard assets perform better -at least relatively - or the US dollar and bonds will hold and even strengthen temporary, while stocks and commodities perform relatively poorly. My bet is that the Fed will move up interest rates very slowly for fear to deflate the various bubbles it itself created and encouraged with its ultra easy monetary policy. In particular, the US housing market would seem to be vulnerable to a sudden sharp Fed Fund rise since more and more homes were purchased this year with adjustable-rate mortgages, which carry lower interest rates (at least now) than fixed rate mortgages and led to home price increases in California of between 17% and 33% year-on-year depending on the counties surveyed.
Still, with interest rates as low as they are today, it is unlikely that even a massive injection of liquidity into the system by the Fed will be able to generate new highs for the year in the various stock and commodity markets around the world, as the markets have begun to have second thought about the long term consequences of Mr. Greenspan's irresponsible monetary policy, which will, as just indicated, certainly lead to more inflation and higher interest rates later in 2004 and in 2005. There are two more reasons to be cautious about equity markets. Mutual fund cash positions are at a historically low level (see figure below). So, if mutual fund inflows slow down or if mutual funds are faced with net redemptions the demand/supply situation of the stock market would not be as favorable as it was over the last 18 months.
I may add that the home equity withdrawal phenomenon, I referred to above, led not only to higher consumer spending but also to purchases of equities by the household sector, since not all the money individuals extracted from their homes - as a result of the refinancing activity - was spent. Therefore, if home equity withdrawal shrinks it could also affect the demand side of equities negatively, which might explain the recent sudden decline in inflows into equity mutual funds! Moreover, from the figure below it should be evident that if there were at some point net redemptions in equity mutual funds, these redemptions could only be met by mutual funds selling equities (Please also note how high cash positions were at the onset of the bull markets after 1974, 1982 and 1990.)
Lastly, one group of people, who is usually relatively well informed - the corporate insiders - have turned decisively less optimistic. In the first four months of this year, US insiders have sold US$ 14 billion worth of stocks compared to just US$ 4 billion in the comparable period in 2003. According to a study this is the highest insider selling on record since 1971 when these insider sales statistics began to be compiled. One must, therefore, wonder who will be right - the largely uninformed American public who has piled in into equity mutual funds at the highest rate since January and February of 2000, shortly before the stock market in the US peaked out (but failed in 2004 to move the market much higher), or the relatively well informed insiders who have been dumping shares! I for one, I am betting on the insiders and would, therefore, use the current rebound in share prices around the world as a selling opportunity.