Choosing Between Bad and Worse: The Fed's Unenviable Position

by: Gary Dorsch

Twenty four months ago, the Federal Reserve embarked on a long, but predictable road of lifting the federal funds rate, aiming to reach an unknown “neutral rate,” a sweet spot that would protect both price stability and maximum US employment. At each of the past 16 Fed meetings, the outcome was never in doubt. The Fed delivered a widely telegraphed, quarter-point rate hike.

But closer attention was always focused on the Fed’s statement about the economy that might provide clues about its next move on interest rates. However, for the first time during the current rate hike cycle, there are widely split opinions about which poison the Fed will choose on June 29th, either a quarter-point rate hike to 5.25% or standing pat at 5.00%. Both options carry big risks for the US economy!

The Federal Reserve’s Mandate for Full Employment

When US Labor apparatchniks reported on June 2nd that employers added just 75,000 new jobs in May, the fewest in seven months, and just a quarter of the new jobs created in February, it suddenly became fashionable on Wall Street to predict a pause in the Fed’s rate hike campaign at 5.0 percent. Within minutes before and after the Labor report, the odds of a quarter-point Fed rate hike to 5.25% on June 29th fell to 48% from an 80% chance earlier in the week.

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As evident from the chart above, when the US economy was losing jobs in 2000 thru mid-2003, the Greenspan Fed was quick to slash the fed funds rate in half-point increments, and then kept the overnight loan rate pinned at just 1% for an entire year, until the economy generated between 100,000 and 300,000 jobs per month in 2004. Once job creation was on firm footing, the Fed began to dismantle its ultra-easy money policy in slow motion. As long as the US economy continued to create 100,000 to 250,000 jobs per month, the Fed kept lifting the fed funds rate.

How should traders read the latest slump in US employment below the psychological level of 100,000 jobs? Chicago Fed chief Michael Moskow downplayed signs of slowing job growth, and instead, said the drop in the US jobless rate to 4.6% in May, "likely indicates a vibrant labor market in which more firms may begin to bid up wages to attract and retain workers." He also said the rate of job growth "on balance has been solid in recent months" despite some ups and downs.

Moskow said labor force trends meant that the past rule of thumb that 150,000 new jobs a month was consistent with a steady jobless rate probably no longer held. The figure now may be closer to 100,000 jobs, as growth in the population slows while the percentage of the population in the labor force looked unlikely to rise. Moskow said forecasts for 3.5% growth this year and 3% in 2007 were "reasonable."

The Fed's favorite measure of core inflation that strips out the bare necessities of life, food and energy costs, rose 2.1% YoY through April. Moskow said “1% to 2%” was his “comfort zone" on core inflation but that it was better to be in the middle of that range than stuck at the top. “I think monetary policy should be calibrated to bring us back to the middle of the range over time, and remain vigilant for signs of incipient inflation and adjust its stance accordingly,” Moskow said on June 2nd.

Asked to comment on the financial markets' perception that the May jobs report tipped the balance in favor of a Fed pause this month, Moskow begged to differ. "We look at dozens and dozens of indicators and take all these into consideration in terms of how these indicators influence our outlook for the economy. So you can't single out one single indicator and say that will result in the Fed doing X or doing Y."

Federal Reserve’s Top Priority - Defend the US Dollar

There are other factors besides the US employment rate that could still persuade the Fed to lift the fed funds rate to 5.25% in June. If the Fed pauses at 5.00% on June 29th, currency traders might figure that the fed funds rate had peaked, and after an extended pause, the next shift in Fed policy would be a rate cut. That could trigger an immediate speculative attack against the US dollar against key reserve currencies, such as the British pound, the Euro, Japanese yen, and Swiss franc.

Indeed, the stiff corrections in industrial commodities and gold in the month of May were linked to expectations of a Fed rate hike to 5.25%. US dollar denominated commodities such as crude oil, copper, gold, silver, and zinc, the premier leaders of the “Commodity Super Cycle” could recover their bruising losses suffered last month, if the Fed holds rates steady, supported by a weaker US dollar. Inflation fears could re-ignite in global G-7 bond markets, lifting long term yields by a quarter-point.

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San Francisco chief Janet Yellen, a voting member of the FOMC, is concerned about higher inflation emanating from a weaker US dollar. On May 27th, Yellen said, “A depreciating dollar would appear to call for a response of tighter policy by potentially stimulating export demand, while raising import prices. Appropriate policy actions by the Fed to anchor inflation to price stability, are essential to ensure that supply shocks do not become embedded in inflation expectations."

Cleveland Fed chief Sandra Pianalto warned on May 2nd, that foreign investors could tire of financing the US current account deficit, with serious implications for Fed policy. “At some point, international investors, including governments will become reluctant to add additional US dollar-denominated claims to their portfolios. At that point, higher interest rates on dollar-denominated assets and, possibly, a decline in the spot value of the dollar will be necessary to overcome their reluctance."

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Pianaltos’ dire scenario appears to already be unfolding. While the Fed has restored the federal funds rate to 5.00%, a five year high, the US dollar remains chronically weak. The 30% devaluation of the US dollar index from its double-top at 120 in 2002 to the 84-level last week, was accompanied by a near doubling of the US current account deficit, which measures foreign trade and international financial flows.

The US current account deficit widened to a record $224.9 billion in the fourth quarter 2005, around 7% of gross domestic product. That brought the 2005 deficit to a record $804.9 billion, or 6.4% of GDP. The gap would have been wider without a large swing in foreign direct investment flows to a $107.1 billion surplus in 2005 from a $145.1 billion deficit the year before, largely due to one-off tax breaks offered to US corporations repatriating funds back home. Those tax beaks have expired.

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On April 11th, Dallas Fed chief Richard Fischer said the central bank will do whatever it takes to maintain the integrity of the US dollar, and to insure inflation doesn't "raise its ugly head". "In addition to a faith-based currency, we are the currency of the world and we must maintain its integrity. I will spend every ounce of energy doing that. I have no doubt that my colleagues will do exactly the same.”

Since Fischer’s rhetoric however, the US$ has lost about 4-5% against the Euro and Japanese yen, and the greenback is gyrating at April 2005 levels, when the federal funds rate was pegged at 2.75%. The US dollar is skating on thin ice, and a pause in the Fed’s rate hike campaign at 5.00%, could give currency traders the green light, to probe the US$ index lows near the 81-level set in December 2004.

Bank of Japan and European Central Bank Set to Hike Rates

Nearly two-thirds of the US dollar’s counter-trend rally in 2005 has already unraveled in the past three months, as currency traders sense a peak in the US federal funds rate around the corner. And while the Fed is winding down its rate hike cycle, the Bank of Japan is dismantling its five-year ultra-easy money policy of “quantitative easing”, draining 26 trillion yen ($220 billion) out of the Japanese banking system, and knocking the US dollar to as low as 109-yen in late May.

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Higher Japanese bond yields, a tighter BOJ monetary policy, and a weaker US dollar are taking their toll on the Nikkei-225, which plunged 10.7% from its April high to as low as 15,400 on June 2nd. Japan's top government spokesman reiterated on May 30th, that he wants the central bank to continue supporting the economy with its current policy of guiding key short-term interest rates to near zero percent.

"Monetary policy is up to the BOJ. But we still hope that the BOJ will continue working together with the government to make sure that the economy fully emerges from deflation and will not return to it," said Chief Cabinet Secretary Shinzo Abe. “I think there is a need for them to fully support the economy by continuing with the zero interest rate policy," he added.

Still, futures markets in Chicago and Singapore unanimously predict that the BOJ will hike its overnight loan rate by a half-percent to 0.50% in the months ahead, with Japanese “core” consumer inflation expected to hover near 0.6% this year. A unilateral BOJ rate hike would exert further downward pressure on the US dollar, to the detriment of Japanese exporters to China and the US.

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The other major player, the European Central Bank, is lingering far behind the inflation curve, with the Euro M3 money supply exploding at an 8.8% annualized rate in April, nearly double the bank’s original target of 4.5%, deemed consistent with low inflation. The ECB is expected to hike its repo rate by three-quarter points to 3.25% by year’s end, starting with a 0.25% rate hike to 2.75% on June 8th.

Expectations of a half-point ECB rate hike to 3.00% on June 8th, seem overblown with the Euro bumping against the psychological $1.30 level. Instead, the ECB could opt for the go slow approach with its baby-step, quarter-point rate hikes, once every three months. The Swiss National Bank is sure to follow the ECB with a similar line of rate hikes from a Libor target of 1.25% to as high as 2.00% by year’s end.

Unilateral rate hikes by the ECB could exert upward pressure on the Euro, presenting a double whammy for the EuroStoxx-600 index. Germany's Deputy Finance Minister Thomas Mirow said on May 21st, "The whole story is to be seen through the panorama of the dollar. We do not want to see abrupt changes of exchange rates. So at the level of $1.27-$1.30 we see no acute problems for Germany," he added.

A weaker US dollar subtracts from income of European multinationals that is earned in the United States. And because the Chinese yuan is pegged to the US dollar, earnings from China will also be cut down in size, which is particularly bad news for German industrialists. Ironically, the Bank of Japan and the ECB might welcome a quarter-point Fed rate hike to 5.25%, to help steady the US dollar.

Russia Shifting Away From the US Dollar

The Fed’s job of protecting the integrity of the US dollar became much more difficult, on April 18th, when Russian finance chief Alexei Kudrin questioned the US$’s status as the world reserve currency, triggering an avalanche of US$ sales. Russia’s foreign currency reserves soared by $6 billion to a record high of $243 billion last week, with an increasing share of Euros and sterling, confirming Moscow's cooling to the US dollar as a dependable store of value.

Russia, which is the world's #2 oil exporter, has been piling up FX reserves at a breakneck pace as the central bank buys up petro-dollars and prints Russian rubles to defend a competitive exchange rate. On May 24th, Kudrin said a segment of reserves stashed in a $71.5 billion stabilization fund would be invested 45% each in US dollars and Euros, and for the first time, 10% in British pounds. Euros have accounted for only 25-30% of the central bank's reserves in the past.

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Equally important, the Russian Trading System (RTS) is expected to start trading from June 8th, futures and options for Russian Urals blend crude, and gas oil, fuel oil and jet kerosene. With Russian oil production of more than 9 million barrels per day and exports of over 5 million bpd, Urals output dwarfs the North Sea Brent futures in London and the US light sweet crude in New York, traded in US dollars. Most importantly, the RTS contracts are denominated in Russian rubles, which could greatly weaken European demand for the US dollar.

Upward pressure on the Russian ruble /dollar rate has increased since Kremlin kingpin Vladimir Putin instructed finance officials on May 12th, to make the Russian currency freely convertible by July 1st, six months ahead of plan. Finance Minister Alexei Kudrin, confirmed that schedule, which would make it easier for foreign investors to buy Russian government bonds or Urals futures and options, and also for Russians to invest abroad, following the abolition of capital controls.

The Treasury Bond and Gold Vigilantes Resurrected

The Fed’s dilemma about its upcoming rate decision becomes even more hazardous, now that US Treasury benchmark yields are starting to track the hard dollars and cents that are moving the gold and commodities markets, and to a lesser extent, the inflation statistics fashioned by government apparatchniks. The decline in the US Treasury 10-year yield below 5.00% on June 2nd, was hardly surprising, after gold prices retreated nearly 12% below their 25-year highs of $730 per ounce.

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If the Bernanke-led Fed decides to stand pat at 5.00% on June 29th, as the majority of Wall Street bond dealers expect, it could trigger further US dollar sales, and in turn lift the gold market, possibly as high as $700 per ounce. That in turn, could prompt the G-7 bond market vigilantes to lift long term bond yields, contrary to conventional logic among Wall Street equity salesman.

The Fed’s reckless decision to abandon the reporting of the M3 money supply on March 24th, removed a major source of transparency over the central bank’s operations, and resurrected the gold and bond vigilantes. It will become much more difficult for G-7 central bankers to inflate their stock markets by increasing the money supply, under a market imposed de-facto gold standard.

Fed is “Shooting from the Hip”

On May 23rd, Fed chief Ben “Helicopter” Bernanke taking a question about inflation and interest rates from Senator Jim Bunning, acknowledged that,

“There are some upside inflation risks to the economy. Some additional firming of policy might yet be needed in order to address those risks. We also noted at that time that our thinking on this would be very data dependent. We'd be looking at the data as they come in, making a decision on the full picture, and we have about a month to go.”

Thus, the Bernanke Fed is pursuing a monetary policy of “shooting from the hip”, sizing up each piece of economic data and market blips as they flash across the computer screen. But against a backdrop of high energy prices and with the US housing boom cooling, the US economy's outlook is now more ambiguous, said New York Fed chief Timothy Geithner. This adds to the near-impossibility of getting interest rates at a level that neither stimulates nor hinders economic growth in an environment of stable inflation.

"Economic concepts that are critical to our understanding of the economy may be difficult or impossible to capture in practice. One such concept is the neutral or equilibrium interest rate," Geithner said, adding that the range for such a rate may be as wide as 100 basis points or more, and the center of that range "tends to move around quite a bit."

Geithner noted that, with the boom in the US housing market appearing to be cooling, it is harder to confidently predict if the strength of consumer spending will be sustained. “In any case, but particularly in an environment of rising uncertainty, the Fed must maintain its commitment to keeping inflation contained,” he said, leaning towards the hawkish view on June 29th.

At a Congressional hearing on November 15th, 2005 on his nomination to lead the Fed, the former Princeton professor Ben Bernanke said that ensuring price stability was the means that full employment could be secured. “I will maintain the focus on long-term price stability as monetary policy's greatest contribution to general economic prosperity and maximum employment," he said.

However, the fed funds rate stood at 4.00% when Bernanke vowed to be tough on inflation in November, and has authorized two quarter-point rates hikes as Fed chief, in an effort to shed some of his dovish feathers. Would Bernanke try to convert himself into a hawk by hiking the fed funds rate by a quarter or a half-point above the 5.00% neutral rate to defend the US dollar and fight off commodity inflation?

US Housing Stocks -- Under Siege from Higher Interest Rates

Of course, the biggest risk of a tighter Fed policy is deflating the US housing bubble, a great source of wealth and confidence among US households, whose consumption accounts for roughly 70% of US economic activity. US home building stocks have slid 37% below their all-time highs of August 2005, to their lowest point since December 2004, measured by the Dow Jones US Home Construction index.

"If real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions," this according to Fed governor Donald Kohn on March 16th. In his remarks, Kohn attacked the popular “Greenspan put” theory that Fed policy would always protect investors from sharp asset market drops while doing nothing to restrain these markets when prices rise.

"This argument strikes me as a misreading of history," Kohn said. “Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk. Whatever might have once been thought about the existence of a ‘Greenspan put,’ stock market investors could not have endured the experience of the last five years in the United States and concluded that they were hedged on the downside by asymmetric monetary policy," Kohn said.

"The same consideration applies to US homeowners. All else being equal, interest rates are higher now than they would be were real estate valuations less lofty, and if real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions," Kohn said.

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Pulte Homes (NYSE:PHM) on June 2nd, slashed its full year profit outlook by 20% to $4.85 /share, amid higher interest rates, underlining the slowing of the US housing market and sending the #2 US home builder's shares to their lowest level in 16 months. In April, Pulte, Centex and Beazer Homes all reported double-digit declines in home orders as rising mortgage rates and housing prices pressured buyers. Pulte, said preliminary net new orders for April and May were down about 29% from the year-earlier period, totaling 6,447 units.

On May 24th, recently appointed Fed governor Randall Kroszner argued that a weaker housing market was a good reason to hold rates steady at the next Fed meeting. "We want to think about the unpredictable lags that can sometimes come from changes in interest rates and also changes in energy prices. We are mindful of looking at all the pieces of data on that,” he said.

"We have had strong growth so far this year. It is likely to moderate to a more sustainable pace. We're seeing some evidence of a gradual cooling in the housing market. We want to be looking through the windshield, we don't want to just be looking at the rear view mirror," Krosner said.

Defying the Inverted Yield Curve

The Federal Reserve has gradually lifted its overnight loan rate by 400 basis points to 5.00% over the past 23-months, yet the Treasury’s ten year yield had barely budged. The ten year yield rose by only 55 basis points to 5.00%, since the rate hike campaign began in June 2004. The 6-month US dollar Libor rate is yielding a slightly higher 5.30% in London, and signaling an inverted yield curve.

The last three Fed rate hikes took place while the US 6-month Libor rate traded above the US Treasury’s 10-year yield. Usually, when lenders are willing to accept lower interest rates for longer term debt than for shorter term deposits, it is a signal that the US economy is about to experience a serious slowdown or even a recession within twelve months. The last time the bond market witnessed an inverted yield curve was six years ago, at the height of the frenzy for internet and high tech stocks.

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All US recessions have been presaged by an inverted curve, but not all inverted curves have resulted in a recession. At the moment, the inversion would at least signal slower economic growth, but few traders are convinced it would spell a contraction of gross domestic product for two consecutive quarters, the typical definition of a recession. Still, another Fed rate hike to 5.25% could spell a deeper inversion of the yield curve, heightening worries about an economic downturn.

“I would not interpret the very flat yield curve as indicating a significant economic slowdown,” said Fed chief Bernanke, on March 20th. “Short-and long-term rates are narrowing because investors are willing at accept less risk due to stable inflation, the implications for future economic activity are positive rather than negative. If spending depends on long-term interest rates and special factors lower those rates, then overall demand will be stimulated and a higher short-term rate is required.”

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“Could we make a mistake by carrying the restriction too far? The answer is yes we could. But we have to balance the inflation risk against the risks of undershooting on progress in increasing employment," said St Louis Fed chief William Poole on February 24th.

“Should we make a policy mistake, we should be able to back off without a recession developing. I don't think that the expansion is fragile. And if it turns out that it tapers down, what you'll see is a pretty prompt decline in interest rates in the marketplace, followed by a Federal Reserve reduction,” he said.

The last time the US Treasury market was inverted in 2000, stock market investors were not afraid, and argued that its shape reflected the Clinton administration’s retirement of longer term debt from huge budget surpluses. But the Nasdaq and S&P 500 did begin to implode in 2001 and an eight month economic recession arrived in 2002. Today, in May 2006, there is speculation that the US housing bubble might deflate next, bringing on a recession and an easier Fed policy in 2007 or earlier.

Showdown with Iran, Ayatollah Threatens to Unleash the Oil Weapon

How would the Bernanke Fed and other foreign central banks react to an oil price spike to $80 per barrel or higher, if Iran’s Ayatollah cuts back on oil exports to the hostile nations threatening sanctions in the UN Security Council?

Higher oil prices are bound to exert upward pressure on inflation, and could inspire a recovery in other commodities such as gold, silver, and possibly base metals.

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Ayatollah Ali Khamenei, supreme leader of the world's fourth largest oil exporter, said on June 4th:

"If the United States makes a wrong move regarding Iran, definitely the energy flow in this region will be seriously endangered. We are committed to our national interests and whoever threatens it will experience the sharpness of this nation's anger.”

Khamenei spoke from a podium emblazoned with Khomeini's words "America cannot do a damn thing." His speech listed what he said were US failures in Iraq, Afghanistan, the Palestinian territories and elsewhere in the area. "You (the United States) are not capable of securing energy flows in this region," he said, addressing the crowd who were packed into Khomeini's mausoleum, south of Tehran.

Although Iran holds the world's second largest oil reserves after Saudi Arabia, it lacks refining capacity and needs to import more than 40% of its astronomical 60 to 70 million litres per day gasoline consumption. Although initial reports are sketchy, UN sanctions could include a complete embargo of refined gasoline exports to Iran. Iran’s Mahmoud Ahmadinejad's populist government, which draws its support from the poor, would faced with a very unpopular choice of hiking petrol prices or rationing fuel from September, a big potential source of social unrest, in an economy where the jobless rate is estimated at anywhere from 16 to 30 percent.

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Iran will continue to price its oil sales in US dollars but can receive payment in other foreign currency needed by the central bank, Iranian Oil Minister Kazem Vaziri-Hameneh said on June 4th. "Although pricing is in US dollars, our receipts can be in any foreign exchange.”

A strategic ally of the Ayatollah, Venezuelan President Hugo Chavez said in May that his country might price its oil in Euros. Thus, if sanctions are applied against Iran, the US dollar could come under speculative attack, lending support to dollar denominated commodities.

As for Bernanke’s response to an oil shock, in October 2004 he said:

"I would argue that the Fed's response to the inflationary effects of an increase in oil prices should depend to some extent on the economy's starting point. If inflation has recently been on the low side of the desirable range, and the available evidence suggests that inflation expectations are likewise low and firmly anchored, then monetary policy need not tighten and could conceivably ease in the wake of an oil-price shock.”

Double-Edged Sword for the S&P 500 index

The weaker US dollar helps the S&P 500 index in several critical ways. First, it makes US products cheaper overseas, which is crucial considering that roughly 40% of S&P 500 corporate profits come from overseas operations. Second, a weaker dollar makes it harder for foreign companies to compete on US soil, giving US based companies more power to raise prices at home. And most immediately, S&P 500 companies that sell goods overseas can book instant gains when they convert foreign currencies back into US dollars.

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But a weak US dollar that is breathing on life-support can also be a negative factor for the S&P 500, if the Fed decides that its top priority is to defend the greenback above all else. Other central banks might follow Russia and switch their US dollars to other reserve currencies or hard money such as gold. The point is, the global money markets are far ranging and very complex to figure, but it is simply wrong to view Fed policy through a narrow domestic prism.

After a brutal sell-off in from May 11th thru May 24th, the S&P 500 index recovered half of its previous losses, while the US dollar stayed pinned near its May lows. It is natural for bargain hunters to emerge from the sidelines to pick up badly battered stocks after a sharp downturn, and then spout reasons for others to join the buyers bandwagon. But expectations of a pause in the Fed’s rate hike campaign, due to a weak employment number in May, weaker housing stocks, and an inverted yield curve, sound like better reasons to buy 5% Treasury bonds.

The Fed must choose its poison on June 29th, and if the central bank decides to defend the US dollar with a rate hike to 5.25%, then the post-May 24th rebound in the S&P 500 index would unravel as a sucker’s rally. A showdown with Iran’s Ayatollah could loom on the horizon with further instability in crude oil prices. Please read our March 13th, 2006 report, “Countdown to War with Iran? Mixed Signals.”

And ironically, as was evident in the month of May, the only way G-7 central bankers could put a small dent in the “Commodity Super Cycle” and the gold market, was to signal tighter monetary policies and accept sharp declines in global stock markets, in order to lower inflation expectations. Weaker stock markets are portrayed by schizophrenic hedge fund traders as indications of a global economic slowdown, which in turn, could lead to weaker demand for commodities.