A Rally for Stagflation - The Market Gets the Fed Wrong Again

By Dr. Duru written for One-Twenty

June 30, 2006

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TraderMike is correct to be wary of the same old "buy because the Fed is done" song that we have been hearing all year. You faithful readers know that I too have been a skeptic from the beginning. So, let me get straight to the point. The market got it wrong again. The Fed did NOT say that it is finished or even that it is close to finished. We can only guess that they are closer to being finished because rates cannot go to infinity and at some point, the economy will get crushed. Where that point is, lots of folks have guessed in the neighborhood of 6%. What I heard in this latest statement is that the Fed is willing to take rates as high as required to stamp out the inflation threat. To me, that point still looks like the point at which the Fed breaks the back of the economy. This means we could get higher inflation, higher interest rates, and poor economic performance (like anemic or negative growth) = stagflation. We rallied on Thursday over this exciting prospect. Stagflation or not, we cannot get overly excited about the prospects of the end to the Fed's rate hike campaign. That event will be your signal that economic growth has finally been compromised. It will be a time to sell stocks, not buy them. But at least you will get a nifty rally to sell into. Let's look a little closer at my skepticism.

First, yesterday's rally was a classic counter-sentiment move. Folks had actually begun to fear the Fed's next pronouncements too much. Talk about a 50 basis point move sure helped build up some additional negativity to play on. The end result rolled out as I suspected in a previous missive, but the beginnings of the rally threw me for a loop until I thought about it a little harder. Recall in my earlier missive that I claimed the typical end of the quarter pumping of the markets would put particular pressure on the stock action following the Fed meeting. What I missed is the pressure it put on the pumpers before the statement. If you had even the slightest conviction that the market had become too negative in anticipating the Fed statement, then you had to get ahead of the call. Wait and the expected post-Fed pop would leave you in the dust. So, the buyers went straight to work from the opening bell. And once the Fed delivered the "not-so-bad" wording that the bulls had hoped for, the dogs were let loose. Instead of selling on the news, those buyers stuck to their stocks because the end of quarter portfolio performance was at stake. (Same logic applies for why you could not expect a significant pullback on the last day of this quarter). All remaining buyers were forced to move or risk completely missing every easy penny. Now, of course, I am over-simplifying things, but I believe I have described the psychology of the moment even if I do not have an accurate depiction of the actors and actresses on the stage. Also excuse me if I sound a bit conspiratorial, but the recent numbers apparently prove out the notion that pumping is happening at the end of quarters and that pumping has been pushed earlier to avoid suspicion - ironic as that is. (Thanks to TraderMike for the link). We would have had some kind of rally even without the pumping - it is just that the pumping exacerbated the buying pressures for the day.

So now that we have our rally, can we find some encouragement, some warm pocket of solace? During the May-June correction in the markets, we have seen three or four very big rally days - depending upon your definition. Thursday's rally on the S&P-500 takes us back to even for June but below the highs of the month from one of those big rallies. The wounds have not healed. Looking forward, I see problems. I am not bearish. I am just not bullish. That is, I still want to ride any rallies for all they are worth, false as they may be, but I am not willing to "buy into" the rallies. I will parse out the Fed statement to clarify my concerns. You know I get a perverse enjoyment out of doing this. But I think it is better to read the statement for what it is and not interpret the statement colored by the market's knee-jerk reaction to it. Besides, in a week or two, you will wonder what all the excitement was about in the first place. Treat this missive as a handy-dandy reference (=smiles=). I will provide "Dr. Duru-speak" paragraph-by-paragraph:

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 5-1/4 percent.

No surprise there. "Everyone" was expecting at least that much. Those who also bought into the nonsense speculation about 50 basis points could find some kind of strange relief out of this part of the news.

Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

The Fed is proud of the fact that it apparently succeeded in slowing down the housing market. The term "gradual" is thrown in there to generate confidence that at least a crash is not happening. I will leave the housing crash talk for another day. More importantly, the Fed finally recognizes that all these rate increases have got to have an effect on the economy at some point. High energy prices must have an impact at some point as well. This statement gives the optimists hope that the Fed will pause to at least wait to see how the economy handles all these rate hikes and price increases. However, bookmark the notion that economic growth is "moderating." It is an important part of my skepticism around being bullish on stocks. The second part of that sentence should cause you alarm because it means inflation could yet flare up more as higher energy prices continue to work their way into the economy. In fact, that is exactly what the Fed refers to next...

Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.

Ah ha! The Fed remains on inflation watch. They are not convinced that the inflation threat is over, despite the ability of companies to keep wages down via productiity gains or the notion that speculators and consumers are maintaining cool heads over the future prospects of higher prices. Energy and commodities are now the main focus of the Fed. It is there it sees high prices. Since the Fed cannot increase supply of these resources, it has to cool demand - that is, the "utilization" of those resources. How to do that? Keep raising rates until people finally get the point and stop building, consuming, and driving so much. As I stated before, once the Fed accomplishes this mission, the economy will be compromised. How can I get excited about that? Remember, the bad news is good news trick worked back when we were trying to climb out of a recession. Every decline in interest rates was like a ray of sunny hope that better days were ahead. Now, with the economy still robust (albeit "moderating"), bad news really is bad news. We will not get any rate reductions until the Fed notices that the economy has started to tank too hard, too fast. By then, you will have a lot of buyer's regret.

Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.

I do not think the Fed could be any clearer here. It is not necessarily finished. Despite what the market (apparently) chose to believe on Thursday, the Fed clearly states that it will continue to base future hikes on the data. It is the same message the Fed has delivered to us for some time now. Take off the rose-colored glasses, and we understand this to mean that more rate hikes could be in our future! We cannot even assume that the next hike will be the last. To do so is to predict that inflation will take a convincing break and maybe even the economy will have another soft landing. And who around here can make these predictions? Especially if the commodities markets complete the current recovery, we will be right back to where we started. While I believe the Fed's recent jawboning of the markets did the trick in cooling speculation, the "real" economy is humming right along (despite many dire predictions to the contrary two and more years ago - present company included!). The last GDP reading was still over 5% right? China, Brazil, and India are still growing at a blistering pace, right? Well, therein rests the seeds for future inflation. And if inflation suddenly disappears, watch out, a global slowdown is likely around the corner if it has not already crawled into our collective skins.

Dare I say we have a good ol' conundrum going? I outlined the issue last month in a glib sort of way with an infinite loop type of diagram showing how we could bounce back and forth from inflation scare to economic cooling and back again. The conundrum is that while we wish for the Fed to quit, the current conditions for quitting seem to point to an economic slowdown that we do not want. Even worse, short of a recession, the inflation threat may not go away fast enough to satisfy the Fed. This is a recipe for stagflation: poor economic performance and higher prices too boot. Cheer all you want about the end of the Fed's hikes. But I think the Fed is locked into a showdown with economic growth that we will lose no matter which way it comes out. And we do not need a replica of the 1970s for things to feel unpleasant.

The next step on the horizon is the earnings season. Should that be a catalyst for higher stock prices? Well, if we believe the Fed, and listen to our desires for a slower economy (to encourage the Fed to leave us alone), I do not see how July's earnings reports can contain a lot of upside surprises. If the economy is really cooling, and companies are honest, we will get our fair share of earnings warnings and/or subdued projections. If we get a lot of blistering confidence and stellar results, well, then you know the economy is not even close to cooling off enough to satisfy the Fed. Get it?

In the meantime, be careful out there!

DrDuru, 2006