Did The Fed Make A Mistake? Let The Markets Tell You

Includes: GLD, TIP, TLT, UUP
by: Gary Jakacky

Like President Obama with chemical weapons, Ben Bernanke swallowed his own ideas about our economy finally having crossed the line into reasonable growth. There will be no taper for a while. He is slave to the data: presumably data which shows the economy is not growing fast enough.

Personally, I think the FED made a mistake. One need only follow the excellent series of posts by Calafia Beach Pundit here on Seeking Alpha to realize that our economy, while growing slowly, is gathering strength. That strength is offset by some weakness in the (Federal) government sector as spending growth has slackened. But as the Pundit has always pointed out, this is exactly the medicine the economy and the Federal Budget need right now. In this case the FED needs to stop keeping interest rates (Fed funds/short term rates, specifically) artificially low.

The latter penalizes savers and rewards those who took on too much debt. And we wonder why growth lags behind historical averages?

In the final analysis however, it is not my opinion or anyone else's that will determine if the FED's action was the correct one. The opinion that matters comes from our stock, bond, commodity, and currency markets, which represent the action (not the talk) of millions of investors who put their money (not chatter) on the line.

Yes, the one day response to Bernanke was positive. But what will the long term response be, after sober analysts have a chance to really swallow the consequences of the FED decision?

  • Bonds: Treasury bonds have been trending lower through all of 2013. Some say it is fear of a taper: other say it is because the economy is showing strength. Now we can resolve this dilemma. Look at the chart below of the iShares Treasury Bond ETF (NYSEARCA:TLT). If bonds resume their decline and fall below their recent bottoms at 102.50 or so; the answer is clear: bonds are falling due to strength in the economy. If the rally in Tbonds continues, the markets are telling us the fear of the Taper is gone and long term rates can safely fall for a while.

Source of all charts: www.bigcharts.com

  • Gold: While not exclusively an inflation hedge (it can also rise due to international tensions), gold prices are sensitive to inflation concerns. Look at the chart of the SPDR Gold Trust ETF (NYSEARCA:GLD). The rally in July and August was probably due to Syria: notice how it backed off when tensions eased. Any further gold strength is probably due to fears of inflation from easy money and no taper. The FED is being inflationist: they wish to avoid the Japan debacle. But if gold prices drift lower, and especially if they drop below $115 or so, the FED has it wrong: interest rates are being pushed up by a strong economy and holding GLD is a wasting asset.

  • Indexed Treasury Bonds: These can also cast an important market vote on the FED decision. Like their TLT cousin, iShares TIPS Treasury Bond ETF (NYSEARCA:TIP) rallied strongly on Bernanke's statement. If indexed bonds continue to rally, and especially if they outperform the TLT portfolio, it is telling us markets expect greater inflation, lower interest rates, or both. In contrast, if they drift back to, and especially below, their summer double bottom just above $108, the decision goes the other way. The economy is strong, inflation will stay low, or both.

  • The Dollar: like Gold, the value of the dollar is sensitive to international politics, plus decisions by other countries (e.g. China) to manipulate their currencies. So unlike some analysts, I don't think the value of the dollar will be too good an indicator about the appropriateness of the FED action. Nonetheless, some pundits do say that if the dollar gets trashed in the near future and breaks below last year's low of $21 on the Powershares DB US Dollar Bullish Fund (NYSEARCA:UUP), markets are telling us another dollar crisis (and consequent financial crisis) is looming. That cannot be what the FED wants. Oddly enough, on the other hand, if the dollar rallies, it also proves the FED wrong: higher real interest rates would be making our currency more attractive. If you find this palette of explanations a bit confusing, so do I. That is why I suggest you pay more attention to other markets.

  • Stocks: if the Fed's decision was a sound one, we should expect the market to continue to rally. Like the dollar chart above, however, is odd how these cards play out. The market has rallied strongly in recent years right in the face of the weak growth that the FED is so concerned about! What gives? After adjusting for risk, recent strength in cyclical and health care stocks suggests the economy will show more strength down the road. So do the recent solid earnings by FedEx (NYSE:FDX) and other transportation companies. Even in the face of higher oil prices, the Dow Transportation Average has been stronger over the last year than the S&P500. Just how is the FED responsible for that hidden gem?

With stocks then, investors must be more savvy. If stocks hit new highs, watch which sectors are performing well. If it is interest rate sensitive sectors like Utilities, or slow growth staples, the scenario is that no Taper means lower interest rates across the board for quite a while.

If it is cyclical and growth stocks which lead the rally, as my article yesterday suggests has been the case this summer, then the FED has it backwards and the economy is strong. This is especially true if the Transportation stocks move higher.

If the market falls, the verdict is clear: the FED messed up, big time. Many analysts and government bureaucrats think Wall Street is hooked on cheap money. The FED just gave them what they wanted. The gauntlet has been thrown down. Watch the markets above and see the answer in the next few weeks.

Disclosure: I am long XLV, IHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.