From the time the FOMC began the most recent easing cycle, I have been talking about and demonstrating the direct correlation that existed between the stock market and the target rate - since the FOMC began offering the target rate in 1997. The references I have made, and the charts that I have provided, show that there has been a direct correlation between interest rates and market direction for the last 10 years. When interest rates trend higher, the market trends higher, and when interest rates trend lower, the same thing happens to the market.
Soon, I expect this correlation to break.
The FOMC is near the end of an easing cycle introduced to support a diving economy, but at the same time they are sacrificing control of inflation, and this is dangerous. Arguments on policy decisions aside, the recent cuts are clearly being made to foster an immediate positive impact on the market, even though rate cuts take about 6 months to gain traction. Maybe the rationale is purely psychological? Regardless, the FOMC will soon have a new problem to deal with: core inflation.
For the past 10 years the policy decisions of the FOMC were related directly to economic growth, and core inflation was a virtual non-issue. That has changed, and with that the direct correlation between the target rate and the stock market will change as well.
The interest rate cut coming this week will almost surely be the last one that Bernanke will provide to the economy.
Inflation is like a cancer which spreads rapidly through the economy. We all know food and energy prices are increasing exponentially, but now those are creeping into core prices too, and that's where it starts to spread like wildfire. The worst part of the current scenario is that the FOMC has relinquished control of inflation. We have already seen proof from the Airlines. The price hikes from United Airlines (NYSE:UAL), Delta Airlines (NYSE:DAL), American Airlines (NASDAQ:AMR), and Northwest Airlines (NWA) are just the beginning. Shipping and other costs are going up for every manufacturer and those higher costs are finding their way to consumers and businesses. The next round of price hikes are likely to come from companies such as Federal Express (NYSE:FDX) and American Express (NYSE:AXP). From there, products offered by Proctor and Gamble (NYSE:PG), 3M (NYSE:MMM) and Johnson and Johnson (NYSE:JNJ) are poised to increase too. There's no way to avoid this, and with interest rates as low as they are, companies can pass these costs along and increase core inflation measures accordingly.
The divergence between the target rate and market action will take place after the Fed begins to raise rates in the face of inflation.
After Tuesday's rate cut, the market will realize that the Fed is done, and when it does, the market will increase with the expectation that the need for additional intervention is over. In 1-2 months, some of the rate cuts will be reversed out of the economy to save inflation, and once that begins, the divergence between the market and the target rate will begin as well.
The take away: enjoy the next up move in relation to this correlation, because it will be the last of this correlation cycle.
My expectation is for interest rates to increase substantially over the next 24 months and for stagflation to be a resounding theme until the end of 2008, where additional aggressive declines are likely to result in an economic depression.