By James J Puplava CFP, January 10, 2005
It's the beginning of a new year and stocks are off to a slow start. Markets are in negative territory and the financial markets are having difficulties despite upbeat economic and earnings news. The rosy forecast made at the start of a new year is already being questioned. What seems to be the problem? What happened to The January Effect? Money is pouring into pension funds, IRAs and 401(k)s and mutual funds. So why aren't stock prices soaring? The problem is quite simple. It's the Fed. The markets got a jolt last week when the December FOMC minutes were released. The minutes suggest the Fed is less likely to pause in its interest-rate increases this year something the markets weren't anticipating. The tone of the minutes was more hawkish than usual. It appears that Fed officials had more worries on their mind. Specifically the Fed was concerned over three developments:
- Interest rates were too low to keep inflation stable.
- Signs of excessive risk-taking in the financial markets.
- Global financial imbalances, mainly in the U.S.
Is The Inflation Genie Out of the Bottle?
With U.S. interest rates below the inflation rate of 3.6 percent and plenty of money and credit to go around, inflation is beginning to kick up again and it’s becoming noticeable. After a decade of relatively tame prices consumers are beginning to feel the pinch. The price of fuel, health insurance, trips to the dentists, college tuition to tomatoes are all going up. It isn't just in the raw material sector. The cost of everything from coffee and candy, to home appliances is marching higher. Consumer product companies like Procter & Gamble, Hershey Foods, and Whirlpool are raising prices.
Wholesale prices went up more than 5 percent last year. The supply chain absorbed most of the higher costs, but manufacturers are now at the tipping point. It's either raise prices or see your profits erode. The economy is strong enough and consumer spending is robust. This is giving producers more confidence to pass on higher costs. Procter & Gamble raised coffee prices 14 percent the largest price increase in more than a decade. Whirlpool raised prices from 5-10 percent on everything from refrigerators to washers and dryers.
Today the Commerce Department reported that inventory levels for manufactured goods rose again in November. Inventories have risen 10 of the past 11 months. One of the theories that is helping to explain rising inventory levels is inflation. Some economists believe companies are hedging rising prices by building up higher inventories to minimize their exposure to rising raw material and energy costs. Low interest rates make it easier to maintain higher inventories. It is much cheaper to finance inventory than it is to pay higher prices especially if raw material prices increases are above finance costs.
What isn't clear at the moment is the start of a new trend of inflation psychology taking hold. If companies start buying in anticipation of higher costs, the inflation genie has been let out of the bottle. Rising prices can lead to greater demand by boosting inventories, which in turn can lead to shortages and higher prices. It can lead to a vicious cycle whereby prices push up wages. This cycle in turn pushes up prices. The process then accelerates through anticipation and eventually leads to higher inflation rates and on a worst-case basis; hyperinflation.
It may be one reason why Fed officials have become overly concerned. Once inflation psychology takes over, it becomes hard to stop. Paul Volcker ended inflation in the early 80's by taking interest rates to levels never seen before in the U.S. It produced the worst recession since the Great Depression. The U.S. economy is far too leveraged today to apply the same medicine. It may be one reason why the Fed has awakened to the inflation monster they created as a result of the bursting of the 90's stock market bubble.
Excessive Risk-Taking in Credit Spreads and IPOs
The other problems the Fed addressed in its minutes were potential signs of "excessive risk-taking." The Fed cited declining credit spreads, the increase in IPO's, and an increasing number of mergers. Yields have across the whole risk spectrum. The carry trade has given rise to closing spreads across all risk categories as hedge funds, large financial institutions, and companies have searched for opportunities to arbitrage. The result is money has gravitated to high-risk areas reducing the risk premium as shown in this chart
Last year U.S. high-yield, or junk bond issuance reached record levels totaling $139.8 billion. That was above the previous year and ahead of the record set back in 1998 at $137.8 billion. Credit spreads on double-BB rated securities are tighter than where they were on the eve of the LTCM debacle.
As to other signs of speculation, the IPO market soared last year with 242 IPOs. Many of these companies (38%) weren't profitable. The trend last year was for riskier, profitless companies to go public. The investment bankers have lowered the standard from 4 years of profit to no profit. Some companies don't even have sales. Today's benchmark for going public isn't clear anymore. It seems to be whatever the market will buy. Last year's most successful IPO was Marchex [MCHX] up 223 percent in 2004. The company had sales of $23 million and no profits. The company has a market cap of $526 million. While no one is comparing today's IPO market to the crazy markets of the late 90's, it is clear that froth has returned. If the trends of the fourth quarter continue with profitless, low quality companies tapping the financial markets, then the financial world has lost its marbles again.
Financial Imbalances Increasing
The third problem that concerns the Fed is the huge financial imbalances that exist around the globe with the biggest imbalances here in the U.S. The U.S. is spending more than it produces, consuming more than it saves, and speculating more than it is investing. This is evident in the U.S. saving rate as shown. The net savings rate as of Q3 of last year was 1.7%, not much higher from the low of 1.2% hit in 2002.
Excessively low yields led to aberrant consumer behavior. In the midst of a recession, instead of paying down debt and building up savings, the American consumer went on a borrowing and spending spree. Americans bought more cars, bigger homes, home entertainment systems and every imaginable consumer good from camcorders, DVDs, to plasma TVs. It was financed mainly through debt. What couldn't be financed with a credit card was paid for through home equity.
Rising real estate prices another sign of inflation and another asset bubble created by the Fed caused consumers to tap into their home equity to pay for this new spending orgy. This is evident in home equity falling sharply and in the income to debt levels.
This debt and consumption binge has led to a monster-size trade deficit that shows no sign of letting up. The trade and current account deficit approached 6 percent last year a level where most currency crises begin. In fact these imbalances have become a great concern to the international community. In a meeting in Basel, Switzerland this weekend, central and commercial bankers met on Sunday to discuss ways to maintain economic growth amid growing concerns over the U.S.' exploding twin deficits. IMF officials warned that the U.S. budget deficit is "truly excessive."
While officials were concerned over America's huge twin deficits, they were equally concerned over signs that the global economy was beginning to slow. Japan's economy looks like it is heading into recession or at least on shaky ground. Europe doesn't look much better. The problem is that in the rest of the world consumer demand is almost nonexistent. That leaves only the U.S. as the "purchaser" of last resort. This has led to record trade and current account deficits with foreigners buying up our financial assets as shown in the graphs right of treasuries and corporate bonds. We buy their goods and they in turn buy our financial assets. The U.S. is in effect hollowing out its economy. Foreign holdings of U.S. assets now exceed $10 trillion versus U.S. claims on foreign assets of $7 trillion. The result is a net deficit of $3 trillion. It is the one reason why the dollar has been falling and losing its value against other currencies.
The problem for the Fed is that in order to correct many of today's imbalances would require lots of pain. High levels of pain are something politicians and central bankers are reluctant to administer. It would mean a deep recession, if not a depression, high unemployment and a complete rethinking of U.S. economic and tax policies. The U.S. trade deficit is structural and won't be solved by devaluing the dollar. The dollar would have to drop by another 50% before the trade deficit would begin to correct. Imagine what kind of inflation rates or high interest rates would accompany such devaluation. That is why authorities will take the easy way out by raising interest rates gradually, which will keep real interest rates negative, a fact that in itself is inflationary. The other policy prescription will be to depreciate the dollar, which is another inflationary prescription.
Something's Gonna Break
That is why the markets are heading into another financial storm. The Fed will keep raising interest rates until something breaks in the economy or the financial markets. All of this will occur at a time of extreme complacency. Last week's reaction by financial experts to the Fed minutes was one of optimism. The "Goldilocks" theory was resurrected again to explain Fed increases. The Fed will raise rate gradually and get the economy into a position where it isn't too hot or too cold. If that doesn't work, then the experts will move on to another euphemism "the soft landing". By the time the financial markets start talking about a "soft landing," you'll know that things are starting to break either in the financial markets or the economy. Which comes first? I believe it will be the financial markets that break first.
The Fed has a name for what is coming. It is called "neutral," although Mr. Greenspan is fond of saying that he doesn't know what neutral is until he gets there. Don't forget that Mr. Greenspan has been warning the markets for a long time. In a speech given in Germany last year he said, "Rising interest rates have been advertised so long and in so many places that anyone who has not appropriately hedged his position by now, obviously, is desirous of losing money."
What is clear from recent Fed minutes and speeches given by various Fed officials is that much higher interest rates are on the way. That is a message that doesn't bode well with today's giddy financial markets that are over-leveraged in speculative positions. As short-term rates rise, the carry trade could come to an abrupt end as long positions in bonds-treasuries, junk, and sovereign are unwound. A nasty bursting of the bond market lies directly ahead unless it is thwarted by massive foreign central bank intervention.
What we do know when the Fed embarks on a rate raising cycle is that financial markets or the economy break down. The hallmark of the Greenspan Fed is to inflate and create asset bubbles, burst the bubbles and then reinflate and create new bubbles to replace them. Greenspan began his tenure as Fed chairman in 1987 by raising the discount rate 50 basis points at a time of extreme interest rate fragility. The stock market eventually crashed. In response to the crash, Greenspan flooded the banking system with reserves by massive buying of government securities. This pattern was repeated with each new bubble and the Fed's response to a problem. The Fed raised rates in 1990. Those rate hikes were followed by a recession and the S&L crisis. The Fed aggressively raised rates in 1994, which led to a peso and derivative crisis and Orange county bankruptcy. Then again in 1997, the Fed flooded the markets with money in response to the Asian crisis, then again in 1998 after LTCM and Russia's debt default. It repeated the pattern in 1999 in response to liquidity concerns over Y2K. Finally, it began to reverse course in 1999 and in 2000 by raising interest rates. The result was the bursting of the technology bubble and eventually the recession of 2001. The Fed reversed course in 2001, slashing interest rates aggressively, taking the federal funds rate down to 1 percent. Predictably, numerous bubbles rose in response in the mortgage, real estate and bond markets.
Houston, We Have A Problem
Initially the only response to Fed inflating was asset bubbles. Now however, inflation is spilling over into the real economy. It is now visible on Main Street in addition to Wall Street. So what we have today is inflation manifesting itself in all of its forms-asset inflation in the bond, stock, and real estate markets, rising prices in the real economy in raw material, service, and basic goods prices, and in a record trade deficit. It is no wonder the Fed is worried. As long as inflation surfaced in the financial markets or real estate, it could be called a bull market. Now that it is surfacing at the grocery store, department store, dentist and doctor's office, college campus, it becomes a problem.
The Fed can’tappear impotent when in fact it has lost control of the economy and the financial markets. So it will raise interest rates to minimal levels. As the graph of Fed rate hikes left shows, those interest rate hikes won't be as high as in the past. The U.S. economy has become far too leveraged to withstand high single-digit interest rates much less double-digit interest rates. It appears now that interest rates will be raised at each of the next four FOMC meetings in February, March, May, and in June. This should take the fed funds rate up to 3-3 1/2 percent. That is unless something big breaks, i.e., a major hedge fund collapses, a major financial institution gets into financial trouble, default rates skyrocket, and the U.S. economy rolls over.
Something will give and it will be big when it happens. Then the Fed will know it has arrived at "neutral." The next course of action will be to lay the groundwork for the next inflationary cycle so the "deflation" trump card will surface again. It will be time to fool the bond markets again, which have been lulled into sleep by the "carry trade."
Meanwhile, the financial markets are asleep with complacency. Long-term yields are artificially low, the VIX is near record lows, stock valuations are high, froth has returned to the IPO markets, and mergers have come into vogue again. It is usually at extreme levels of complacency that rogue waves or 5 and 10 sigma events have a way of surfacing. Just like the Christmas tsunami, they surface when you least expect them. A massive earthquake triggered the Asian tsunami. Let's hope the coming Fed rate hikes don't trigger similar seismic events.
Stocks retreated in the last hour of trading barely managing to hold on to gains. The Dow Industrials gained 17.07 points, or 0.2 percent, at 10,621. The S&P 500 rose 4.06 points to close at 1,190.25, while the Nasdaq picked up 8.43 points to finish at 2,111. Helping stocks on Monday was news of a handful of mergers. Alltel will buy Western Wireless for $6 billion. Hollywood Entertainment agreed to be bought by Movie Gallery for $850 million. And News Corp. will buy the rest of Fox Entertainment.
The Philadelphia Semiconductor Index dropped 0.3 percent as a major investment bank cut revenue forecast for the industry. In other markets the dollar fell against the euro and the yen. Treasury bond prices fell with yields rising to 4.28 percent on the 10-year note. In the energy markets crude prices climbed as high as $47.30 before drifting back down to $45.33 a barrel.
Chart courtesy: BCA Research, The Gloom, Boom & Doom Report, and StockCharts
© 2005 James Puplava