Following the Fed's Finding of a Strong Economy

By Dr. Duru written for One-Twenty

February 1, 2007

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It's hard to believe, but January actually ended up in the black. After all the ups and downs, chops and churn, the big rally on another Fed day made gains for the major indices a lock. I find it curious that the Nasdaq still lags the Dow and the S&P 500 in the race for ever loftier heights, but we won't quibble with the overall good news. As January goes, we will so goes the year.

So, after pining after any scent and hint of even a smattering of news of rate cuts, suddenly, the market decided it was ready to celebrate on news that the economy still looks strong. In Wednesday's statement, the Fed made it clear that its bias remains on the side of inflation. The main new twist is that the Fed is now ready to concede that the economy looks fine and even housing seems to have bottomed out: "Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters." I am still dumstruck by those who continue to call for rate cuts and have just shifted their expectations from Spring to the second half of 2007. I guess it's all in how much you believe in the current strength of the economy. For now, the Fed believes things are fine, and the numbers keep backing them up. Thus, not only do they have zero reason to even think of a rate cut, but they must maintain serious thoughts of hiking rates.

Why do I stubbornly remain on the side of a rate hike? After all, the bond market is still not believing that inflation is a greater risk than an economic slowdown. In my last missive, I pointed out that the very long-term trend for interest rates remains down even after a sharp two-month rally in 10-year rates. And right on cue, interest rates took a deep dive today right at the edge of this downtrend line. These low rates will continue to stoke the economy and buttress the housing market. Another amazing feature of this economy is that it is still relatively unfazed by the slowdown in housing. Part of the reason is that current building activity would look ok, fine even, except that this more "sedate" rate of housing activity comes on the heels of a gangbuster 2005 when housing peaked. But check out the numbers on GDP. The estimate for 2006 is that the economy grew at 3.4%. This is higher than the growth of 3.2% in 2005, the year that housing peaked. BOTH numbers are slightly above the 20-year average of 3.1%. (All reported in the Wall Street Journal, 2/1/2007). In other words, the slowdown in housing may have helped the economy by staying the hand of inflation (not to mention keep many first-time homebuyers in the market). You better believe that if the economy is still growing faster than its longer-term average and the Fed believes that housing has cleared the doldrums, it will have almost no choice but to tighten the screws a little more. The cynics might claim that the damage from the housing slowdown is yet to show up. Or perhaps they will say that this bubble-stained economy simply moved its excess cash from housing to the next tub of hot air (but aren't those Chinese stocks!?!?). I used to be one of those cynics. Now, I can appreciate the moment for what it is. (=smiles=).

Finally, speaking of housing, homebuilder stocks were "en fuego" today! The fun got started right from the open and simply never looked back. It was as if someone had leaked advanced news that the Fed was ready to give its official stamp of approval on the health of the housing sector. The last two weeks have been chock full of earnings reports from homebuilders, and I simply have not been able to keep up this time around with all the individual stories. The bottom line is that folks are still betting that we have seen a bottom, and Wednesday's big moves put us on the verge of another powerful leg up (see the chart of XHB for exmample). However, note that the divergence in performance continues to widen amongst individual homebuilder stocks. Investors have decided to take some homebuilder warnings more seriously than others. Stocks like CTX, HOV, and MTH are nowhere close to new break-outs whereas PHM, RYL, and KBH are itching to go. This growing divergence will be something to watch over the coming months.

In the meantime, be careful out there!

10-year interest rates

The Fed meets this week, and I suspect it will dribble out the same ol' same ol' of late. But the market will be taking one last desparate look for hints of the timing for a rate cut. When the market does not get the news it wants, I will not be surprised by some swift selling, followed by swift buying by those who actually take comfort in seeing how strong the economy remains. Who knows who will win the tug-of-war after that. But note carefully. The dollar is back in bear market territory and the long-term decline in rates tells us that the dollar will remain under pressure for some time. Given the backdrop of a weak dollar combined with a stable American economy and robust global economy, I remain bullish on gold and commodities in general. If the downtrend in long-term rates somehow breaks here, then all bets are off of course...!

Be careful out there!

DrDuru, 2007