In the Very Unlikely Event of Fed Tightening - Ditch the Banks

| About: Financial Select (XLF)

Fed Chairman Bernanke last night showed no concern about inflation, despite the 50% increase in the broad commodity index over the past year. Macroeconomists look at the aggregate inflation numbers and draw misleading conclusions: the commodity indices should be flashing a warning signal, especially because they reprice almost tick for tick with dollar exchange rate.

The good news is that a very small increase in the fed funds rate would have a very big impact on commodity prices: the dollar would soar on any increase in the overnight rate, and commodity prices would fall in tandem.

The bad news is that the yield curve almost certainly would flatten in response to any Fed tightening, and the banks would get clobbered. Because the banks are loading up on Treasury securities at the expense of other assets (e.g. loans), they are especially vulnerable to changes in the yield curve. Loans float with LIBOR; Treasury yields are fixed.

click to enlarge image

FRED Graph

I consider it extremely unlikey that the Fed will move the funds rate during the next year. Bernanke is committed to a macroeconomic framework in which the averages, like Spinoza’s universal substance, consume everything else in the system.

Were they to do so, however, bank common stock would be the biggest victim (along with commodity stocks).

About this article:

Problem with this article? Please tell us. Disagree with this article? .