Could The Fed Lose Credibility?

Includes: DIA, QQQ, RINF, SPY
by: Bill Ehrman

Gavel I really don't understand the comments made this past week by three Fed Governors who discussed at length the possibility of raising rates in April. Their comments about the strength in the labor force and the impending resurgence of inflation seem at odds with the Fed and Janet Yellen's comments after last week's Fed meeting. In fact, it had a swift impact on all financial markets.

As one would expect, the dollar rose appreciably, the yield curve flattened, commodity prices fell as did stock markets. What are investors to think? What is the Fed really thinking? Confusing for sure, but the real danger is the Fed will lose credibility, which, if lost, is hard to regain. Confidence in them is a key factor in analyzing the financial markets. Will there be a change in mindset toward the Fed or their policy?

Ask yourself: why would the Fed even consider raising rates at this point in time as our economy remains in a soft patch, economic weakness continues in the Eurozone and Japan, and China is muddling through (with growth over 6%) with dangers to the downside. I recognize that the employment data continues to improve grudgingly but hourly earnings are not. I also acknowledge that energy and commodity prices have moved up off bottom but overall inflation is still running well beneath 2%.

Does the Fed believe its own revised forecasts put out last week, which had decelerating rates of economic growth with inflation staying beneath 2% until 2018, or not? Is that the scenario the Fed really wants? Is 2+% growth our potential? Something is fishy, and these Fed governors certainly appear out of step with the recent Fed meeting or… are they trying to manage expectations by creating a two-way market?

The final revision to fourth quarter GNP data was reported on Friday; and while it did show small improvement versus the last reported number, the rate of gain in fourth quarter GNP was still an anemic 1.4%, which was down from a 2.0% gain in the 3rd quarter. GNP growth for the year came in at 2.4%. Household spending rose by 2.4% in the quarter but trade and change in inventories remained very weak. Two disturbing numbers in the quarter that don't bode well for future employment and economic growth were a 3.1% decline in corporate profits and a 2.1% decline in capital spending.

Let's exclude weakness overseas for a moment and just focus on the U.S. economy and Fed policy. The Fed is forecasting growth of 2.2% this year down slightly from last year, with further declines in rates of growth in 2017 and 2018 to 2.1% and 2.0% respectively. Inflation is forecasted at 1.2% in 2016, 1.9% in 2017 and hitting the fed target of 2.0% sometime in 2018. Against the backdrop of a weak fourth quarter and continued weakness so far this year, why would the Fed consider another rate hike at this time?

How will the U.S. remain the engine for global growth if the Fed raises rates at this critical juncture?

The Fed needs our economy to regain some momentum before tapping the brakes. Would they risk making the same mistake they made in December when they raised rates? Hopefully a lesson was learned then and they now know better. That is my call.

Economic statistics reported this week support growth in the lower end of our 2-2.5% expected range for 2016: U.S. existing home sales fell 7.1% while inventories rose 4.4%; commercial property sales fell dramatically in February; durable sales ex-transportation declined 1.0%; the consumer comfort index fell slightly to 43.6 from 44.3 the prior week, and Redbook chain sales accelerated to an anemic 0.8% year/year gain from 0.6% year/year gain the prior week. Nothing real good to write home about.

Now let's add to this view continued weakness in the Eurozone and Japan and concerns about growth in China. Germany, the largest economy by far in Europe, grew at its slowest pace in 16 months in March, the European PMI fell to 50.4 and fears of deflation are strong. Draghi and the ECB are throwing everything in its power to stimulate growth but to no avail so far. And Germany is not letting other countries in the ECB spend more to stimulate growth if it would mean increasing deficits. Japan's economy contracted 0.3% in the fourth quarter and core inflation was 0.0%.

Here too, the BOJ has thrown everything but the kitchen sink to stimulate growth by moving to negative rates and increasing the amount of QE. The Japanese government has limited room to stimulate growth, as the country's deficit is already too large. Unfortunately moving to negative rates in both the ECB and Japan has had the reverse impact than expected as investors sold risk assets, bought local currencies and the euro and yen rose which does not bode well for exports from these regions.

China is doing everything in its power to stimulate its domestic economy and fortunately has the capital and will to make it succeed, but it won't be easy. Premier Li Keqiang at the Boao Forum for Asia said on Thursday that the country will cut corporate taxes by $76.8 billion to stimulate growth and support economic reform aiding the shift to consumption/services from production. I still believe that China will expand between 6-6.5% this year, which is better than any other major industrialized country by a mile.

Both energy and industrial commodity prices gave back some of their gains last week after comments by Fed officials about a potential hike in the Fed funds rate in April. It is obvious that a strong dollar hurts commodity prices, as all are dollar denominated which impacts foreign demand. Notwithstanding the dollar, long-term pricing will reflect supply and demand. Remember that there is an April 17th meeting of the global energy producers to come to a production pact limiting supply. I would not be short energy going into that meeting.

On the other hand, industrial commodity producers continue to announce supply reductions and future capital spending cuts. The seeds for higher industrial commodity prices are evident as long as demand continues to grow therefore we are maintaining our equity positions in the well-capitalized, low-cost producers with secure dividends, even after the cuts, over 6%.

So where does this leave us?

Do we believe the Fed will raise rates again in April? Our answer is no. We believe the Fed has the common sense to let our economy and the economies abroad improve in a sustainable way before the next hike in rates. There are, therefore, no changes in our core beliefs. We would take any market weakness caused by the Fed comments to add slightly to our net exposure.

We also think that the horrifically tragic suicide bombing in Brussels may actually benefit the Republican Presidential candidates, as they are considered stronger than Democrats when it comes to National Defense. Unfortunately, I still have not heard a pro-growth agenda from any of the candidates on either side that makes sense to me.

Change is everywhere and so is the opportunity to profit on both the long and short sides of the markets in various asset classes.

Remember to review all the facts, step back and reflect before acting, control risk at all times and do independent research on each investment…

Invest Accordingly!

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