The Moose stays in cash

courtesy Bill Dirlam of www.decisionmoose.com

JUNE 27— Nobody ever wants to jump in front of a dump truck, or for that matter, a central bank announcement, so the markets stay to the curb and wander aimlessly until the Fed’s midweek press release. Then they go nuts the last couple of days trying to figure out what it all meant. Fed meeting weeks are always a bit schitzo, and this one was no exception.

The Fed’s Wednesday message turned out to be the same one the Moose has been pushing for several months: stagflation. Moreover, the Fed appeared to reassert its emphasis on the “stag”, as in stagnant. Observers figured the bank’s governors (with one dissent) still feel that the weak economy and the fragile banking system must take precedence over a growing inflation threat.
After sleeping on it for a night, investors, fearing slower growth and weaker profits, dumped stocks on Thursday, knocking the Dow down 358 points to a two-year low. Money fled into bonds for safety, driving down yields, which in turn weakened the Dollar, spiking commodity prices and gold.

The Fed’s apparent notion is that our economy, beset by high energy prices and beholden to a financial system that is too strapped to make new loans, even if it wanted to, will ultimately weaken enough to curb inflation on its own. Needless to say, that is hardly a comforting thought for stock investors.

Remember that scene from “Butch Cassidy and the Sundance Kid” when the two realize that they have to jump off a humongous cliff into a raging river to escape a posse? Sundance refuses to jump, confiding finally that he can’t swim. Butch replies incredulously, “Are you crazy? The FALL will probably kill ya!”

Inflation? Hell, the ECONOMY will probably kill ya. Thanks, Ben. Very reassuring.
After jumping off the cliff Thursday, stock investors went down a small waterfall Friday (-104 Dow points) but then managed to dog-paddle to shore. It wasn’t a pretty two days, but better than expected consumption and personal income data for May on Friday morning blunted previous fears of imminent depression. (Can you say “tax rebate checks”. How about “one time shot”?)

For now, technical indications are that stocks are temporarily oversold and ready to bounce-- although volume and volatility measures are not entirely conclusive. End-of-quarter-new-quarter follies on Monday and Tuesday can be expected, however, and don’t forget the ECB.
As noted earlier, no one wants to jump in front of a central bank announcement, and the European Central Bank is up next week. Moreover, the ECB decision has become more problematic. They have been the toughest talker on inflation, practically promising a rate hike next week, but lately European economies, led by powerhouse Germany, have begun to show signs of cracking. Stagflation is creeping into the global consciousness.

Whether the ECB will choose to maintain credibility and raise rates as expected, risking recession, or reverse itself and hold steady awhile longer has suddenly become an open question. The ECB only has one mandate—- to fight inflation. It does not have to concern itself with growth and financial stability as the Fed does, although it would be foolish not to consider those things. Whatever the decision, it could have a bigger impact on the investment markets than the Fed’s decision did.

Thinking is if the ECB raises rates, increasing European bond yields’ attractiveness relative to Treasury yields, the Dollar could slide further short term. That would push commodity prices (which are denominated globally in Dollars) higher for U.S. consumers and those in nations whose currencies are tied to the Dollar (China, Saudi Arabia, etc.) U.S. stocks would be vulnerable to more on the downside.

How much of this week’s action is anticipating just such a development is unclear. We won’t know until after the announcement. That’s why folks step back from dump trucks and central banks.

Higher Dollar denominated commodities do not necessarily mean higher euro-equivalent commodity prices, however, and an ECB rate hike would dampen European demand, lessening inflation pressures there. Eventually, that might lead to a slowdown and a weaker euro, provided of course the U.S. is not in a death spiral itself at the time. Since we’ve been six to nine months ahead of Europe for awhile now, nothing is a lock in that regard.

The problem for both the U.S. and Europe is that the excess demand generating the current round of inflation is originating in the emerging markets. The Fed or the ECB playing with interest rates in quarter point increments will not have a direct impact on that demand anytime soon. We have to go through our own demand first to get at theirs, and that can be painful. It can be done, but only if there is enough political will.

The emerging market boom, after all, was born of Greenspan’s 1% Fed Funds Rate, a rate that was lower and kept in place much longer than commodity and bond prices indicated was necessary. Lower U.S. rates essentially make more Dollars available, and since commodities are traded in Dollars, more Dollars chasing a finite amount of goods raises prices. Commodity inflation was born. More accurately, at one percent interest, it was shot out of a cannon.
Since the current Fed has basically ignored market prices from day one, it comes as no surprise that imbalances have developed over time. (Note to Congress: the Fed has done more to spike oil prices of late than any commodities speculator.) In fairness to Bernanke, his predecessor left him with some truly impressive time bombs (like the emerging markets boom, sub-prime and the housing bust, and incipient global commodity inflation). His choices have been difficult. I am thankful that they were not mine. (See ya. Wouldn’t wanna be ya.)

Unless there is a global economic collapse, I’m afraid that the Fed, by ignoring the markets’ inflation signals for almost a year, may have brought us to the brink of the worst inflation we’ve seen in this country in thirty years.

Now mine is only a theory, and I sincerely hope that I’m as wrong as a panty raid at a Vatican convent. If I’m right, however, you’ll want to own gold (to preserve your capital) and several cases of bourbon (to preserve your sanity). No stocks. No bonds.

It might take awhile-- and considerable anesthesia-- to get through, but we will. One day, ten years from now, on a boardwalk by the sea, as you’re blissfully licking a twenty-dollar ice cream cone, you’ll have forgotten all about it.

The Moose continues to hold cash. Bill runs one of the best mid term models with Decision Moose. His humor is as funny as his analysis is insightful. Thank you Bill for all that you do!