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The Fed, Inflation, and a Bear's Bear

The Fed is increasingly finding itself in a tighter and tighter spot.  Two recent articles (in additon to Bill Fleckenstein's recent writings featured on Scott's Investments) help capsulate the issues faced by the Fed and the bigger picture as it relates to economic growth and equity returns.

Cumberland Advisors on Interest Rates and the Policy Squeeze (emphasis mine):

Put it all together and I think we are looking at the sudden realization that the reliance upon anchored inflation expectations is a weak and fleeting reed to rely upon. Markets aren’t stupid, and attention has already turned to inflation risks and the market has begun to price those risks. Add to this dilemma the prospects for the flood of Treasuries on the market that will be necessary to fund the huge federal deficits associated with implementation of the stimulus program, and the implications for interest rates seem obvious. If the market front runs the potential supply of Treasuries, as is likely, then interest-rate increases will accelerate even without the Fed executing its exit strategy, making the withdrawal of liquidity it had injected even more problematic. If the Fed monetizes the debt in an attempt to keep interest rates low, then they are bound to fail on two fronts – both inflation and interest rates will increase. The increase in rates and flood of Treasuries will also crowd out private-sector debt. All in all, it looks like we are in for a period of rising rates, inflation, and slower growth than would have been the case without the heroic rescue. The only question is when it will start.
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Andy Xie, former economist for Morgan Stanley, writes one of the starker warnings I have read on the current market. Definitely a bear's bear, I would recommend the entire article and have included some highlights below (emphasis mine). In addition to warning that the recent rally is nothing more then a bear market rally (to be kind), he also echoes Cumberland's take on the tight spot the Fed is currently in:

Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves.

When the least informed and most credulous get into the market, the market is usually peaking. A rising economy and growing income produces more funds to fuel the market. But the global economy is now stuck with years of slow growth. Strong economic growth won't follow the current stock market surge. This is a bear market rally. People who jump in now will lose big.

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A massive supply of Treasuries would only worsen the market. The Federal Reserve has been trying to prop the Treasury market by buying more than US$ 300 billion – a purchase that's backfired. Treasury investors are terrified by the inflation implication of the Fed action. It is equivalent to monetizing national debt. As the federal deficit will remain sky-high for years to come, the monetization could become much larger, which might lead to hyperinflation. This is why the Treasury yield has surged in the past three weeks....

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The Fed may have to change its stance, even using token gestures, to assure the market it won't release too much money. For example, signaling rate hikes would soothe the market. But the economy is still in terrible shape; unemployment may surpass 10 percent this year. Any suggestion of hiking interest rates would dampen growth expectations. The Fed is caught between a rock and a hard place....

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Movements in Treasury yields, oil and the dollar underscore the return of rational expectation. Policymakers have to take actions to dent the speed of its returning. Otherwise, the stimulus will lose traction everywhere, and the global economy will slump. I expect at least gestures from U.S. policymakers to assuage market concerns about rampant fiscal and monetary expansion. The noise would be to emphasize the "temporary" nature of the stimulus. The market will probably be fooled again. It will fully wake up only in 2010. The United States has no way out but to print money. As a rational country, it will do what it has to, regardless of its rhetoric. This is why I expect a second dip for the global economy in 2010.

While inflation expectations are causing some in the investor community to act, the rest are betting on strong economic recovery. Massive amounts of money have flowed into emerging markets, making it look like a runaway train. Many bystanders can't take it any longer and are jumping in. Markets, after trending up for three months, are gapping up. Unfortunately for the last-minute bulls, current market movements suggest peaking. If you buy now, you have a 90 percent chance of losing money when you try to get out.

Contrary to all the market noise, there are no signs of a significant economic recovery. So-called green shoots in the global economy are mostly due to inventory cycles. Stimuli might juice up growth a bit in the second half 2009. Nothing, however, suggests a lasting recovery. Markets are trading on imagination....

...While rational expectation is returning to part of the investment community, most investors are still trapped by institutional weakness, which makes them behave irrationally. The Greenspan era has nurtured a vast financial sector. All the people in this business need something to do. Since they invest other people's money, they are biased toward bullish sentiment. Otherwise, if they say it's all bad, their investors will take back the money, and they will lose their jobs. Governments know that, and create noise to give them excuses to be bullish.

This institutional weakness has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than those who held U.S. market bonds, and who lost big in Japan and emerging markets in general. It is astonishing that a value-destroying industry has lasted so long. The greater irony is that salaries in this industry have been two to three times above what's paid in other sector. The key to its survival is volatility. As markets collapse and surge, possibilities for getting rich quickly are created. Unfortunately, most people don't get out when markets are high, as they are now. They only take a ride...

...The world is setting up for a big crash, again. Since the last bubble burst, governments around the world have not been focusing on reforms. They are trying to pump a new bubble to solve existing problems. Before inflation appears, this strategy works. As inflation expectation rises, its effectiveness is threatened. When inflation appears in 2010, another crash will come.

If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can.