What Will the Fed Meeting Bring?

by Paul J Nolte CFA, Dearborn Partners. June 23, 2006

By the time the Fed actually meets next week, there will be plenty of chapped hands in the house from all the hand wringing going on in Wall Street. Although the futures indicate that the Fed is certain to raise rates yet again (#17 and counting) and has a near certainty for yet another hike in August, there is a divide between economists about whether the Fed is going too far or not far enough.

Certainly much ink has been spilt about the weak housing data, housing inventories and the prices of housing stocks. This week we got additional data about the economy that still indicated a generally weaker economy. Durable goods, without the volatile aircraft orders, were up a nice 1%, however much of that came from building of inventories and not final demand. Some earnings reports this week, specifically from Federal Express, indicated that the global economy remains relatively strong. (If shipping activity is high – economic activity is high).

What has been interesting has been the financial markets reaction to the news since the last Fed meeting. At that time equity investors were talking about taking out the old Dow highs, gold was well over $700 an ounce and bonds were hanging around 5%. Today, the Dow is tenaciously hanging onto 11,000 and gold long gave up $700 AND $600 an ounce. Bond yields have increased as the Fed has talked up inflation. So if inflation remains a concern, why has gold declined by nearly 20% and the equity markets, both domestically and internationally, gone crazy?

Let's look back at what happened at the last Fed meeting and subsequent events. At that meeting, as was expected, they raise interest rates yet again and put language into their release giving them the latitude to do as they wished at the next meeting – from raising again to actually pausing for the first time in two years. By the way, this tightening cycle is unusual in the fact that there has not been at least one pause along the way, or for that matter, a hike of 50bp. (So maybe the complacency in the markets are warranted?). Initially, the implication from the Fed release was that they would pause at the June meeting as economic growth was slowing. So investors began watching the economic reports that would indicate whether economic growth was slowing or speeding up.

However, once the statement was issued and the governors hit the "rubber chicken" circuit, something amazing happened – all the talk from the governors was inflation-centric. Ben Bernanke, in some circles, has a credibility problem regarding comments made when deflation was a primary concern. To burnish his inflation fighting credibility, he – and other governors – began talking about how high the inflation rate was, concern about whether it would slow, and the likely inflation in the pipelines from the energy sector. Investors were tossed for a loop and began selling before asking any questions. So investors began watching inflation indicators from the National Association of Purchasing Managers reports to import/export prices – noting that many of these figures remain at elevated levels (although well off their peaks of last year), and began to fret even more, pushing up yields and selling stocks. Today, six weeks after their last meeting, the fed funds futures have gone from a less than 50/50 chance of a June hike and nearly zero chance of one in August to a 100% June hike and over 80% August change.

So where do we go from here? Our prognostication for the year was a decent beginning to the year before falling during the middle quarters and finishing relatively strong with an overall market that would finish unchanged to down as much as 10%. We have seen little in the market so far to change our views. Many of our indicators, however, indicate that we have completed the first phase of the decline and we could see a rally in stocks over the coming weeks – unwinding some of the selling of the past three weeks. Looking at Rydex data of money going into the short funds, money has piled in at a rapid pace (especially OTC) and stands at levels last seen in 2003. Option activity has been heavily on the put side, again indicating investors are looking for lower prices ahead. Finally, many of our momentum indicators have hit levels that were also last seen in 2003 – the last important bottom of the current move. These indicators alone don't mean that the markets go straight up from here, but that much of the initial selling pressure has abated and we could at least stabilize before rising over the coming weeks.

Today's Market

For the third consecutive week, the markets finished lower, with the Dow the closest to unchanged. Bonds continue to price in another Fed hike as 10 year bonds approach the 5.25% implied by the fed futures – still maintaining a relatively flat to inverted yield curve. Crude oil once again crossed above $70, even after another 8-year record high in inventory levels. Gold finished slightly higher, breaking a five-week decline taking bullion down from a $732 high to a current $588 an ounce. It should come as little surprise that all eyes will be on the Fed meeting next week – expect an early fireworks show before the July 4th respite the following week.

Paul Nolte

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