The Fed can�t be happy with the market�s reaction to its 25 basis point rate cut. The 10-year Treasury sold off on the news, taking the yield up to 3.54% from a record low of 3.08% barely two weeksearlier. The 10-year could continue to fall as more leveraged speculators close out their bets on direct Fed purchases of government bonds. It is telling that interest rate sensitive stocks fell inunison last week because it indicates that investors don�t necessarily view the rise in rates as temporary. Just take a look at the charts of LEH, CFC, BZH, CTX, and GS for a view of the damage thatwas done. Rising interest rates are, of course, a prerequisite for the consumer led recession we are predicting in 2004. Consumer spending will fall by at least one full percent of GDP once therefinancing boom ends � data indicates consumers pulled out and spent approximately $100 billion per year in home equity in 2001 and 2002. And keep in mind that interest rates don�t even need to riseto end the refinancing boom, merely stop falling. How big an impact does a half point rise in 10-year Treasuries have on the housing market?
An excerpt from a recent Barron�s article: �Sanford C. Bernstein strategist Vadim Zlotnikov calculates that every half-percentage point rise in the 10-year Treasury note keeps another three million potential home buyers from qualifying for a mortgage on a median-priced home. Higher rates would also cut into the expected $80 billion in consumer liquidity expected to come from mortgage refinancing this year.�
Durable goods orders were weak while home sales were strong. Personal income ticked up by 0.3%, but personal spending by only 0.1%. Jobless claims improved slightly to 404,000, but were above 400,000 for the 19th consecutive week. The GDP price deflator was 2.4% for the first quarter, down slightly from 2.5% in the fourth quarter, which means that deflation is still not even a blip on the radar, which is�.
One of the reasons the 10-year Treasury has sold off so hard in recent days. The May minutes of the FOMC meeting revealed that the Federal Reserve isn�t really that concerned about deflation, calling it a �remote possibility�. In fact, it is increasingly apparent that the Fed is shamelessly attempting to manipulate investors into carrying out monetary policy on the Fed�s behalf now that the Fed can no longer influence interest rates directly through the federal funds rate. There are two significant problems with the Fed�s strategy.
First, the Fed is running the significant risk of losing credibility with the public. Like the boy who cried wolf, who�s going to believe the Federal Reserve if the risks of deflation ever really do increase, now that the Fed has blatantly used the �remote� danger to trick investors into buying government bonds once already?
Second, seat-of-the-pants policy making is bound to have unintended consequences. For instance, bond prices experienced the largest drop after a monetary policy easing since 1986 last week � surely not what the Fed expected or wanted. Furthermore, it is unclear whether the Fed fully anticipated the consequences of its May statement. Although the sharp drop in long-term rates that followed its May announcement apparently delighted the Fed, the meeting minutes don�t mention a desire to influence bond yields � an odd omission if its announcement was intended specifically to �talk� rates lower.
All of which leaves the impression that the Fed is in uncharted waters, struggling to deal with an economic environment, which isn�t particularly amicable to its monetary policy tools.
Watch interest rate sensitive stocks, the dollar, and gold over the next few weeks for clues about the likely direction of interest rates. The Fed has made it abundantly clear that it intends to keep the federal funds rate low for the foreseeable future, but that doesn�t mean that bond investors will cooperate by bidding up Treasuries. The long, secular bond bull market that started in 1982 is quite likely over � or nearly so – and 3.08% could be a yield that isn�t seen again for a very long time. Confirmation will come if interest rate sensitive stocks continue to decline, the dollar starts to fall once again, and the price of gold resumes its rise�.
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
Gold is $345.25 and is close to completing a classic one-half to two-thirds retrenchment. The yellow metal is likely to trade sideways for a few weeks as the dollar finishes its weak bounce, but should then start a move higher that could take it fairly quickly to the $430 to $450 range. The dollar index is 95.02 and still bouncing off its most recent low. The greenback might make 98 � 100 temporarily, but could easily flame out sooner given the huge and growing current account deficit and the Fed�s inflationary policy.
Forecast: The market is showing clear signs of distribution and the likelihood of an 8%-10% decline is very high. Strong internals continue to argue for another try at 1050, perhaps by the fall, but secular bear markets have a funny way of turning controlled corrections into panic driven routes�. forewarned is forearmed.
While I cannot provide personalized investment advice or recommendations, I welcome feedback and observations by subscribers. You can email me at [email protected].
Christopher Norwood manages the Keystone Fund, and the Keystone Stable Fund. To learn more about Chris and the funds he managesCLICK HERE.
Disclaimer: Chris Norwood is the president of Thunderbird Management, which manages three hedge funds in Indianapolis, Indiana. Mr. Norwood periodically publishes columns expressing his personal views regarding particular securities; securities market conditions, and personal and institutional investing in general, as well as related subjects. Mr. Norwood�s columns are not intended to constitute investment advice or a recommendation to buy, sell, or hold any security.
