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Posted 3/28/2005
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Caught in the Fed's inflation trap
Forget its new inflation-fighting posture; Fed policies led to inflation, the governors are late to the battle and they can't do much about it because stocks, bonds and housing already look weak.
By Bill Fleckenstein
The Fed may have used the proverbial "measured" in its communiqu last Tuesday, but there was nothing measured in the various markets' responses to the news that day. I think it's worth attempting to make some (admittedly subjective) sense out of the action, in the interest of clarifying whether the news moved the markets -- or if the markets were simply waiting for an excuse to move.
Did Fed fess up to a mess-up?
By now, I'm sure everyone is aware of the party line -- that the Fed may be telling the market there's more inflation than it had previously acknowledged. To that I say, no kidding. However, let's take a look at the facts: The Fed is the engine of inflation. Greenspan has spawned two separate bubbles, as I've discussed ad nauseam, and inflation has been raging for some time.
If, in fact, the Fed is acknowledging inflation, then it's admitting it's been behind the curve -- since, up until Tuesday, the Fed has been telling us that everything is basically under control. This acknowledgement should serve to undermine the Fed's credibility, not reinforce it. However, that does not appear to be the conclusion playing out in the markets. Thus far, the markets are acting like the Fed still has all things under control.
Bonds already ripe for a rout
Here is my explanation for what happened last Tuesday: Until very recently, the fixed-income market has, to some degree, ignored inflation and the Fed's previous six rate hikes. But in the past month or so, this market has started to act dodgy. On Tuesday, it got hit pretty hard by the news that the Fed was going to do the obvious. The fact that a small word change by the Fed did as much damage as it did, given what the Fed has done so far, tells me that Tuesday's bond market sell-off was more or less a move waiting for a reason to happen. In other words, the sell-off was coincident to the Fed's news and not really caused by it.
All around the world, credit spreads on bond yields have been record-tight for just about anything until recently, and players have made tons and tons on the carry trade (borrowing at low short-term rates and investing in longer-term instruments), which is no longer a profitable strategy. The fixed-income market has been supported by a combination of central banks, carry-trade players and yield pigs.
The fixed-income market also has been supported by folks who've believed that deflation was right around the corner -- when, in fact, what's been around the corner at every juncture has been inflation, not deflation. As I have maintained all along, the problems in this country will lead to inflation until foreigners refuse to finance us and the dollar collapses. Only then, in my opinion, can we potentially experience deflation. We may get to that point, but we're not there yet.
Related news and commentary on MSN Money
In any case, all of the aforementioned fixed-income participants have lately seen the rug pulled out from beneath them -- with last Tuesday being just another bad day in the nascent bear market for fixed income.
Other correction-compatible markets
Meanwhile, given the action in fixed income, the move in the stock market that day was not surprising. Also, the euro was sort of set up for a correction and had some negative news of its own recently. So, I suspect the currency's decline on Tuesday occurred because it already was correcting. It was not because of anything the Fed had to say.
What was surprising was the shellacking the precious metals took on Tuesday and Wednesday, because the thought process I've shared about the box that the Fed is in ought to be bullish for metals. But, if the majority still views Alan Greenspan as large and in charge, then the selling makes sense.
In addition, just as fixed income is held by many leveraged participants, there are many momentum-oriented commodity-trading funds that own gold. They were seen as sizeable sellers of gold midweek.
In short, I don't believe that all the markets looked to the Fed communiqu and responded en masse last Tuesday, as if the Fed were the almighty power in possession of a magic anti-inflation potion. If that had been at work in the metals, why would the bonds have gone down? We could find other discrepancies in the "logic" that reportedly moved these markets.
To sum up the Fed's present position: It is trapped, it is behind the curve on inflation and it can't do much about the problem (even if it wanted to), due to the problems that I have pointed out in the financial system. I think that the key moment in time will be when folks realize that the Fed is trapped.
Winds of an unwinding
As for equities, maybe there will be a bit of a bounce in the next couple weeks, but I think it will fail, as I believe the top is in and the path of least resistance will soon lead downward. Likewise, I think there's a good chance that the speculative mania in housing has reached a crescendo, though it remains to be seen when we will actually start to receive data points that confirm its demise.
Of course, having housing, stocks and bonds in trouble is not going to be bullish for the economy. And, when the economy weakens enough to reduce inflationary pressures, our massive leverage will become a big concern. All of these will be factors in "the next time down," and that scenario, as regular readers know, is one that I believe will also be friendly to the metals.
We are at a point in time when there are many crosscurrents, as leveraged players and moment-to-moment hedge-fund operators buffet all these markets. The noise-to-signal ratio is likely to be extremely high for a while. That is why it's important to decide what it is you believe, so you won't be shaken out of the positions that express your viewpoint.
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