Has the Fed Already Squashed Speculation and Inflation?

By Dr. Duru written for One-Twenty

June 12, 2006

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It has been "raining stocks" for about a month now (a phrase I borrowed from TraderMike). Supports have failed, rallies have failed, and former high-flyers have been smashed. The housing market continues to lag and related stocks keep punching out new 52-week, and sometimes multi-year, lows. Homebuilder executives are now talking about how expensive land looks and proudly proclaiming that they will wait for better entry points to do additional acquisitions (see webcasts from Meritage and the Toll Brothers 2006 Analyst Day for example). They have announced that speculators have become (scared) sellers. All of this talk suggests presages deflation down the road. Commodity prices have tumbled although oil stubbornly hovers over $70 per barrel. But this fear-led levitation has not helped oil-related stocks that have fallen just as hard, and often harder, than the rest of the stock universe. Emerging markets are submerging. Whispers are again making the rounds that hedge funds that have crowded into the same risky trades will need to soon unwind and dump in one big crescendo. All of these beatings have come from a growing fear that the Fed might actually win the war against inflation, and win it at the expense of a robust economy. As some proof of this fear, 10-year Treasuries have recently fallen back under 5.0% and remain within the long-term down-trend: hardly the kind of levels you would expect of a market whose long-term inflation expectations were at danger levels. So after all of this carnage, we must ask...has the Fed, uh, "won"?

Well, the Fed has been hiking rates since the summer of 2004. It spent most of the past two years insisting that inflation was under control. Nevermind the irony that only after two years of hiking rates is the Fed starting to admit anything different. With this kind of record, you have to suspect that when the Fed worries about something, we are approaching the end of our need to worry about it. I doubt this week's inflation data will reflect the bloodbath in the previous leaders of inflation incendiaries. Heck, let us not forget that many of these prices have run so far and so fast that they still might look high to an inflation hawk. Perhaps the inflation numbers in July will start to show some cooling. It is hard to say. Recall that these indicators are just now showing what we have felt for a while with rising home prices, oil prices, gold prices, etc... So, if the Fed is winning, I would have to think the success may not show up in these numbers for some time. And since the Fed claims not to care about stock prices and does not take them into consideration in forming policy, the Fed may be blind to the market's much storied powers of discounting. This must be another fear of the market: as the Fed keeps its eyes on what just happened, it will miss what is happening now. That is, it tightens too much. Of course, the perma-bears out there will laugh immediately at such a thought. The Fed needs to tighten and tighten fast - just stamp out all remaining vestiges of the big bubbles of the last 5+ years and teach everyone a good, long-lasting lesson.

One thing we do know is that the market will try to discount the future even while the Fed is discounting the past. This means that regardless of the CPI numbers, the market will have plenty of reason to be unhappy. If the numbers repeat the warning signs from May, we will get a repeat of the walls of worry growing higher and higher and blocking out all hope. The Fed will tighten the life out of the market. Or inflation is rising faster than the Fed can contain it. If the numbers show a pause (a hiccup?) in inflation pressures, the market may first rally at the prospect of the Fed also taking a pause but then resume to worry that the Fed will fall behind a true trend of growing inflation pressures. If the market somehow gets in a good mood - that is, the sellers finally leave the building - perhaps a rally on low inflation numbers will last long enough until we get the next round of Fed meeting drama.

I am just trying to propose some scenarios and food for thought. My main point after all of this is that the market has been smashed on a whole bunch of yapping by the Fed. The Fed has actually done nothing yet. Even when it has provided no new news, just the yapping alone has sent chills down the market's collective spine. All this dire and dark talk about inflation running higher than it should has produced plenty of action in the markets. And it may be the effect the Fed wants absent a rate hike later this month. If these inflation indicators are worth their salt, they should show some signs of an easing from May's horror story. If not, well, we'll save that lamenting for another missive!

Be careful out there...! And don't forget to look at those CD rates around 5%!

DrDuru, 2006