The Fed positively surprised the financial markets last week by lowering rates by a half percentage point - a larger amount than was anticipated. Although the stock market rejoiced as the "reflation" trade was immediately back in play, the Fed’s action was a disappointment for those of us who advocate a sound currency and believe that the unfolding correction of credit excesses (which the Fed appears determined to forestall) was a healthy and overdue development.
By cutting the Fed Funds rate by 50 basis points in the face of a clearly unfinished campaign against inflation, Bernanke & Co. compromised its inflation-fighting credibility and perpetuated the "moral hazard" problem of bailing out Wall Street and rewarding risk-takers and borrowers while penalizing savers and conservative investors.
We couldn’t agree more with the Wall Street Journal’s editorial entitled The Fed and Character, which ran the morning after the Fed’s aggressive rate cut:
The point we’d like to stress today concerns the Fed and its credibility - or to put it more tartly, its character. It is easy for a central bank to cut rates and ease money. At least in the short term everybody loves a good time, as yesterday’s equity euphoria showed. The harder task is being willing to tighten money amid the business and political criticism that inevitably follows. That’s the true test of a central banker’s mettle.
We’ve argued that the Fed hasn’t shown that character in many years, which is a major reason it found itself this week having to choose between the risk of higher inflation and a potential recession. A central bank that stresses preserving the value of the currency when it isn’t popular will have more credibility to ease money when it really needs to. As Chairman Ben Bernanke looks beyond today’s crisis to what he wants his own legacy to be, we hope he’ll make a restoration of the Fed’s character his main priority.
While we clearly disagree with the manner in which U.S. monetary policy has been and continues to be conducted, our investment strategy must deal with conditions as they exist, rather than how we would prefer them to be. Our portfolios have been defensively positioned because of the combined risks from the piercing of the credit bubble and the ongoing vulnerabilities of the housing market. We have been operating under the assumption that the risks of a bear market and recession were sufficiently high to warrant a conservative investment posture. The conclusion that must be drawn from last week’s events and market action (i.e. a powerful, broad based rally in stocks and economically sensitive commodities) is that those risks, at least in the near term, have been reduced.
However, we are going to remain patient and wait for additional signals before putting some of our cash reserves back into risk assets. Specifically, we want to see evidence of the following:
1. Bottoming in the housing market, which continues to be a major risk factor for the economy. We will be closing watching three indicators in particular to gain confidence that the housing sector has reached a bottom: (1) A peak in the inventory of unsold homes; (2) a convincing bottom in housing-related equities; and (3) an improvement in the home price outlook from the S&P Case-Shiller Housing futures markets, which are currently projecting double-digit home price declines in nine out of ten major metropolitan markets in the U.S. over the next two years.
2. Stabilization in the currency, commodity, and Treasury bond markets. While the stock market was soaring in the wake of the Fed’s ease last week, the U.S. dollar dropped to fresh lows, prices of key commodities rose to new highs, and the yield on long-term Treasury bonds jumped 25 basis points. All of these moves are reflective of higher inflation expectations in response to Fed easing. In our view, stock prices will have a very difficult time sustaining upside progress unless commodity prices, especially the prices of oil and gold, settle down, and the U.S. dollar stabilizes.
Moreover, it will be very instructive to watch the behavior of longer-term Treasury yields, now that the Fed appears to have abandoned its vigilance towards inflation. Longer-term yields remain contained at the moment, but can adjust very quickly. It would be ironic if the Fed acted principally to support an ailing housing market only to find that rising inflation expectations and a weak dollar caused a spike in longer-term bond yields (which have a much greater effect on mortgage rates than does the Fed Funds rate), putting further pressure on the housing market.