Are we there yet?

I wrote my first commentary back in January about the pending decline in the fx value of the US dollar due to the large and growing macro-imbalances (current account and budget in the U.S.). Leon den Exter e-mailed me a very good (and in retrospect, right on target) question in response to my e-mail:

"Is it then conceivable that the Fed rate could be further (significantly) increased this coming year, despite what the current market expectations are based on the Fed comments? To further offset the trade deficit created by the import/export imbalance."


So my second commentary was my response to his question:

"You must have a lot of faith in Hellicopter (or Weimar) Ben Bernanke. As a side note, it will be interesting to see if our boy Benny is a serious public servant or yet another Bush administration crony. I am leaning towards the former, but only time will tell. At least they didn't try and stick us with Phil Gramm (former Republican senator who was a partisan hack) as Fed Chief.

The answer to the question is maybe. It would help the correct the imbalances in the U.S. economy. The problem is that if the Fed raises rates too high, it could bust the housing bubble. That would probably be a death blow to the U.S. economy.I actually think it would a positive, I think we need some pain (real pain) across the board in order to restore financial stability. In the long run, a short-term but severe recession could help avoid what I believe could be the next Great Depression.

I would say that there is a 75%/25% chance that once the economy slows from the Fed rate hikes, they will begin to cut rates (this seems to be what the bondmarket is forecasting). This will temporarily grease the economy and put us back towards the edge of calamity."


Are we there yet?

So now we are here: at the point mentioned in the question/answer above, or at least it is perceived that we are that point. The market seems to be impressed (even scared) by the manhood of Benny Bernanke, in his new role as an inflation-hawk. He has raised the Fed Funds rates twice to 5% since he took over from Easy Al Greenspan and is threatening (or promising) to raise them at least once more. In addition, central bankers around the world have done their part by raising rates, tightening the money supply, and talking tough on inflation. Please note that the actions of the Bank of Japan will also be a key driver of future events due to the potential for the unwinding of the yen carry trade - this is a huge and important topic in itself and I wouldn't do it justice in a one or two paragraphs. If you are interested in finding out more, send me an e-mail or comment on the blog site and I will point you to some readings).

In response, equity markets have tumbled, the yield curve has inverted and credit spreads have begun to tighten. Commodity prices have corrected back to two month lows (look at gold and silver over the past three weeks). By the way, I am still extremely bullish on metals as an inflation hedge as you will see at the end of this commentary.

My current view remains exactly the same as it did in January, this guy is not an inflation-hawk and probably would not even know what it would mean to be an inflation-hawk. As the convoluted, distorted, incomplete Core CPI rate has finally started to show the inflationary pressures from years of loose monetary policy (you see, the housing boom - and the commodity rally to a lesser extent - was really just an outgrowth of inflation but the CPI calculation does not use asset prices as an input) Bernanke has talked tough, his exact words were that these increases were "unwelcome" and "not consistant with a stable monetary environment".

So Wall Street is now worried that Bernanke is going to "go too far" in his fight against inflation and tip the economy into a recession (why did they not see this six months ago as everyone knows it takes somewhere between 6 - 12 months for a Fed tightening to make its way through the economy?). I think this has already happened as you can see the macro-environment weakening across the board from a collapsing housing market to a stalling job market (not unrelated to housing) to stagnant hourly wage increases. Inflation, at least Core CPI, is a lagging indicator - so by raising rates to combat the rise Core CPI, the Fed has probably already over tightened and will have to continue to raise rates at least one more time to maintain its credibility. So we won't see the impact of these latest rate hikes until late in 2006 when the economy will probably be in or near a recession.

So why do I say that this guy is not an inflation-hawk? Well, because I don't think it takes an inflation hawk to hike rates when the economy is still seen as strong (that is part of the problem of distorting growth and price statistics - look at the fake housing numbers - you get distorted decision-making). Everyone still talks about how strong the economy is and I'm sure that most of these people believe it, and this group includes Bernanke. So it is easy for him to stand up and talk tough on inflation - he thinks this is a free opportunity to establish his anti-inflation credentials.

However, the real test of an inflation-hawk (and this is where Greenspan failed) is their willingness to raise rates and tighten policy - or at least not loosen it - when the economy is slowing or even in recession. To inflate the money supply and increase credit everytime there is a blip in the economy makes you an inflationist. All these guys have been doing over the past eight years is postponing the inevitable and necessary economic corrections by printing money and pumping up asset prices (first equities, then bonds and real estate, and finally commodities).
However, while a severe recession would bring cleanse the system of waste and maladjustment, it would require a degree of pain and forbearance, a virtue in short supply in today's markets and society in general. Ben Bernanke, in particular, does not have the stomach or belief system for us to "take our medicine" and will lower rates and print money like there is no tomorrow when the economy turns the corner and heads down in a meaningful way.

Not sure if this will be in late 2006 or early 2007, but it will happen. This is what the bond market is telling us that much with its inverted yield curve. Market participants expect rates in the future to be lower than at the current time.

When Ben starts to loosen monetary policy and lower rates then the real fireworks will start. The dollar will fall (slowly at first), gold/silver will skyrocket and the stock market/housing prices will stabilize or even move to the upside. It will also put us firmly back on track for the 2008-2010 economic collapse which will finally wipe out the imbalances, distortions and malignancies in our economy and perhaps in society as a whole. This will be the topic of next week's commentary - the mass delusion of American consumers and whether an actual economic depression would actually be a good thing (in the long-run).