Markets About to Turn the Screws on the Fed?
Below is an extract from a commentary originally posted at www.speculative-investor.com on 25th October 2006.
A massive credit expansion facilitated by the Fed's monetary largesse fueled one of the world's greatest ever stock market bubbles, and when this bubble eventually went 'pop' in 2000 the Fed facilitated an even greater credit expansion in an effort to mitigate the economy-wide effects of the bursting stock market bubble. At that point the credit expansion began to influence other markets to a much greater extent than the stock market, causing a juvenile real estate boom to develop into the 'bid daddy' variety and setting in motion major upward trends in commodity prices.
After two years of large rises in the prices of houses and commodities the Fed began to fear the consequences of the inflation it had worked so hard to create. It therefore began to apply some gentle pressure to the monetary brakes via numerous baby-step hikes in the official interest rate, but thanks mainly to the easy-money policies of other central banks -- primarily the Bank of Japan -- the Fed's attempts to stabilise prices came to almost no avail. It wasn't until the second quarter of this year, when the Bank of Japan began to participate in the monetary tightening campaign, that tighter monetary policy began to take a significant toll. At that point commodity prices reversed course and the nascent downturn in the real estate market became more pronounced.
With commodity prices appearing to have set major peaks, with the US yield curve having become inverted and with the housing market having gone from extremely hot to moderately chilly, the Fed put its rate-hiking program on hold.
If the stock and bond markets are to be believed then the Fed got it just right. That is, the majority of stock and bond market participants seem to be operating under the assumption that the Fed ended its monetary tightening at exactly the right time: late enough to eliminate the inflation threat and remove the speculative froth from the property market, but not so late as to severely curtail the pace of corporate earnings growth and bring about a major downturn in house prices.
The consensus that the Fed 'got it just right' is evidenced by the performance of what we call the "Expected CPI" (the difference between the yield on a standard 10-year Treasury Note and the yield on an inflation-protected 10-year Treasury Note). As illustrated by the following chart, the "Expected CPI" has spent the past three years oscillating between 2.25% and 2.70%. It moved up to the top of its 3-year range during the second quarter of this year, but has since drifted back to near the bottom of this range alongside corrections in some high-profile commodities and rallies in financial assets (stocks and bonds).
But how realistic is the prevailing "Goldilocks" view? Or, putting it another way, what are the chances of the US economy actually being relatively unscathed by the most irresponsible monetary and fiscal policies since the days of F. D. Roosevelt?
We don't think the chances are good. In our opinion there is a high probability of the financial markets and/or the US economy doing something to let the Fed know, in no uncertain terms, that it ended its rate hiking either too soon or too late.
We actually don't think there's any possibility that the Fed ended its rate hiking campaign too late, but if the US economy plunges into a severe recession during 2007 then the collective finger of blame will no doubt be pointed at the Fed's last one or two rate hikes. This is because few people will realise that it was the flood of easy money that preceded the modest monetary tightening, and not the monetary tightening, that paved the way for the downturn. In other words, if events unfold in this way then the finger of blame will be pointed in the right direction for the wrong reason.
The way things are going, however, there appears to be a much greater chance of the markets doing something that makes it look like the Fed stopped its rate hiking too early. In particular, the most likely time-window for cyclical lows in gold, gold stocks, copper and oil ends over the next couple of weeks, and with the notable exception of oil these markets have held above their June lows. If they soon begin to trend higher then in all likelihood so will the "Expected CPI", and by January the Fed might well be in the position where it is forced to resume its rate hiking to quell the surge in inflation expectations and avoid a consequential breakdown in the bond market. And if there's a sufficient inflation scare to provoke a resumption of the rate hikes then the entire "Goldilocks" thesis falls apart.
In summary, we doubt that the Fed will be able to smoothly transition from a cycle that involved one of the most incredible monetary experiments in history to a more normal monetary cycle.