The Fed reduced short-term interest rates by 50 basis points last Tuesday. That was 25 basis points more than the market expected and the response was rapid and predictable:
• The Dow and other major averages rallied over 2%
• The Dollar fell as Gold and Oil rose.
• Long Bonds fell as the spectre of increased inflation loomed large.
We find ourselves asking if this is the beginning of a larger trend or yet another 1-day wonder in what has been 2-months of unbelievable volatility.
The fact that commodities continue to outperform against financial assets implies that the probability is weighted towards further inflation. In fact, the Feds policy of bailing out markets no matter what, is a highly dangerous inflationary policy.
Chart 1 - CRB index outperforming Long Bonds since the beginning of 2007
Our outlook is therefore for higher long-term interest rates ahead and is corroborated by the intermarket picture:
Chart 2 - Intermarket analysis of Dollar (top); Bonds (middle) and S&P500 (bottom)
In late July we showed the above chart with purple rectangles. Our intention was to show how Bonds were tracking the movements of the Dollar with an approximate 3–month time lag and the stock market to Bonds with an equal lag. At the time we drew the Blue arrow against the S&P500 (red line) indicating that we thought that based on the Bond market moving lower, the stock market was about to do the same (which it did). What has subsequently taken us by surprise is the extent of the rally in Bonds (green line) since the June lows. Bonds became the recipients of a flight to safety as the credit crunch set in. Now the market feels the Fed is on the job and Bonds are losing their safe haven appeal as inflationary fears have come to the fore. Higher interest rates will also exasperate the housing bust! If the intermarket picture remains accurate then the top should now be in for Bonds (the US Dollar made its intermediate top about 3 months ago – red arrow). The stock market should continue to rally for a few more months, perhaps back to the July highs. Then it should reverse lower.
What we therefore envisage is that this rate cut will be one of many as the market, left alone, will sink under its own weight and will require constant support. This will be good for current Gold prices and current Oil prices which we feel offers the best risk return in the current market environment.