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“Assuming, of course, the always latent danger of terrorism in the United States remains in check”, it is certain that the Federal Reserve Board will raise interest rates at next weeks FOMC meeting. However, what is considerably less certain is how the US economy and stock markets will perform during the upcoming Fed tightening cycle.
Given that the Fed is about to hike interest rates for the first time since May 2000, it is not surprising that next weeks meeting is receiving extra attention. To be sure, at the risk of saying something that isn’t memorable before a period of potentially volatile change, analysts have been grappling with extremist-type scenarios.
Fleck Still Anti Greenspan
Bill Fleckenstein has been writing about the markets since 1996. Bill Fleckenstein has been ridiculing the Greenspan led Fed since 1996. Although little has changed, Fleck has taken on a more confident tone in recent attacks:
“The next big trade is the Fed losing its credibility. Whether you want to express that view by being short stocks, or by being long metals or foreign currencies, it doesn't really matter.” June 21, 2004
Luskin Optimistic
Donald Luskin, chief investment officer of Trend Macrolytics, agrees that interest rates must quickly rise [to stem inflationary pressures], yet he doesn’t see any dangers on the horizon ‘with more normal rates’.
“Yes, yes, I know. You don't want the Fed to raise interest rates because that will "squelch the recovery" or "burst the housing bubble" or "hurt the consumer" and all the rest. Sorry, I don't believe any of that. Sure, there are people who've gotten used to a couple of years of unusually low rates, and a few who will squawk when rates inevitably go up. But we're in a strong recovery, and overall we'll do just fine with more normal rates.” June 18, 2004
Which extremist will be right?
Fleck’s belief that the dollar is in trouble – a view that I happen to agree with – is nonetheless myopic given that it is partially faith, not scenario driven. In other words, contrary to Fleck, logic tells us that ‘if Al cranks up rates’ this could support the US dollar (although the unbelievable pace of Asian purchases of US debt is cause for concern, there is no strict crystal ball when it comes to forecasting future interest rate/dollar trends. In other words, previously US interest rate fears have briefly supported the dollar, and if US interest rates rise this could continue to support the dollar for some time).
“If Al goes wild and cranks up rates, the economy would tank. Given all the debt we have, so would the dollar. The financial system would be a mess, and the price of metals would go higher. If he decides to stay behind the curve, at some point inflation will grow until it can't be hidden any longer, causing the dollar to go down and metals to go up.” Fleck
As for Luskin, his opinions carry an anti-Fleck tone. Perhaps also, Luskin’s opinions are anti common sense. After all, in Luskinland the hot US housing market and debt laden US consumer are symptoms of economic success not the eventual cause of economic ruin. In Luskinland ‘Rate Hikes Are Good’ and, only if the Fed doesn’t raise interest rates quickly enough, inflation is bad.
The point to be made about Fleck and Luskin is not that neither offers invaluable viewpoints on how monetary policy will impact the US economy and financial markets. Rather, the Flecks’ blame the Fed for creating unsustainable bubbles while the Luskins’ blame the Fed for not keeping the party/or bubbles going. In short, given each analysts predilection for the ‘next big trade’, speculators need only apply to these big ideas.
As for a more middle of the road analyst, Stephen Roach - who was ahead of the curve in forecasting the need for a 3% FF rate earlier this year (the Blue Chip Survey of fund managers now agrees with Roach) - he gives investors plenty to think about:
“The Great Enabler [of the asset economy] has now created the ultimate moral hazard: overly-indebted consumers and overly-exposed financial institutions, both of which are exceedingly vulnerable to a long overdue normalization of monetary policy…” Roach
The Unknowns of Monetary Policy
The term ‘prophetic monetary policy forecast’ is an oxymoron.
A decade of monetary ease failed to jump start Japanese consumers and investors in the 1990s. By contrast, in America the mere mention of a Fed rate cut sends stock [asset] prices soaring and consumers to their nearest leveraging outlet. Yes, one of the most daunting challenges in deciphering the potential impact of a US monetary policy shift is that there are few precedents to study. Question: How will/can the US dollar fed world wean itself off of the superior size and liquidity of the US economy and financial markets?
The Statistics Say What?
That the US Fed has pledged to raise interest rates at a ‘measured pace’ and Fed futures are pricing in a 25 basis point rate hike at every Fed meeting scheduled for the rest of 2004 is mind-boggling: although the investor may not want to trade the potential impact of a Fed policy shift, they nonetheless must consider the long-term implications the shift might have on their portfolio. As always Wall Street has got the optimistic angle covered:
“Over the past two decades, stocks have never delivered a negative total return during Fed tightening cycles” Note from Merrill. TheStreet
What this statement fails to mention is that stocks were in an unprecedented bull market over the last two decades, and that the tightening cycle preceding this bull market was exceptionally painful one for stocks. No matter, what Merrill also neglects to mention is that stocks have actually declined during the current Fed loosening cycle.
To reiterate: stocks have actually declined during the current Fed loosening cycle.
Suffice to say, although the investor may not be able to figure out exactly when all the rate hikes will arrive, rest assured the investor is also lost when it comes to the impact on stocks.
Speculation: US Policy Shift Good News?
“He presided over the longest U.S. economic expansion and has received credit for keeping the two recessions on his watch short and shallow.”
We all know how Mr. Greenspan helped keep the last recession short and shallow: following 9/11 – which occurred during the recession – Greenspan aggressively continued cutting interest rates with one of two scenarios in mind: 1) a Federal Funds rate of 0%, or 2) economic recovery. Number 2 has occurred this time around.
Incidentally, when it comes to terrorism, Luskin sees no cause for concern. He does, however, neglect to mention that Greenspan and company – which quickly cut rates by quickly by 150 bp in the two months following 9/11 – would not be able to react in the same manner to a similar crisis today. To reiterate, if asset prices collapse due to an unexpected crisis (the crisis could be falling asset prices themselves), or if terrorism rears its ugly head and threatens to dent consumer confidence, the Fed is not prepared to cut interest rates as aggressively as they did during 2001. Such is what the Flecks have been arguing for a long time that the Fed needs more ammo.
Is Greenspan an Inflation Fighter?
“Former Fed Chairman Paul Volcker broke the back of inflation by focusing on the amount of money in the system, letting the price of money (i.e., interest rates) go wherever it wanted to. Easy Al Greenspan and his current crop of money printers focus primarily on the price of money, spewing out as much as needed. Even when they supposedly tighten, all they do is raise the cost of money. They never restrict the supply of money.” Fleck
Ironically, Volcker – admittedly dealing in a different interest rate environment – grew the M3 at a stronger pace during his tenure than Greenspan did during his first 8-years. What is more, only during Greenspan’s tenure did the M3 actually post a year-over year seasonally adjusted contraction.
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This is not to suggest that Greenspan is a more diligent Fed Chairman than Volcker. On the contrary, whereas everyone despised Volcker’s tough actions against inflation, everyone loves Greenspan today...
Quite frankly, it is not Greenspan’s trigger happy printing press finger that makes him one of the most reckless Fed bosses ever. Rather, at any whiff of trouble central bankers print money – this is what they do! No, what makes Greenspan reckless is his 1990’s ‘productivity’ comments, his unbelievably sanguine comments pertaining to OTC derivatives and hedge funds, his failure to hike margin rates during the mania, his speech last week, etc.
Luskin fails to credit Fed rate cuts for helping to create the potentially temporary and dangerous US economic recovery. To his credit, Fleck points out that Greenspan has been a bust because he is busy accepting cheers instead of working hard to ensure that the next financial crisis will not be a systemic one. With everyone Kung-Fed fighting - trying to make big trades before China takes over or ruins the financial world as we know it - one truism bows in front of us: a loved central banker is about as useful at preventing the next financial crisis as Exxon approved emissions standards are at combating green house gases.
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