11-Jun-04

The Fed's Monetary Policy Dilemma

Marc Faber
We have pointed out before that the year 2003 was unusual in the sense that every
asset class including bonds, stocks, real estate, and coodities went up in price!
"hen, we had after #ebruary$%arch of this year all asset classes &e'cept for real
estate & declining in price and, now, since id %ay, we have all asset classes
including stocks, real estate and coodities, but e'cluding bonds and the () dollar,
oving up in price again - this largely as a result of a assive onetary e'pansion
engineered by %r! *reenspan! + a entioning this because it is for the ,erican
#ederal -eserve possible to increase the oney supply e'ponentially .in the last four
weeks at an annual rate of ore than 20/0 and keep () interest rates signi1cantly
below the rate of in2ation .see 1gure below0! 3ut by 4printing5 too uch oney the
#ed pushes also the () dollar down and creates eventually higher in2ation rates,
which will one day in future also drive interest rates uch higher!
+n fact, whereas, as can be seen fro the above 1gure, the #ed fund rate is currently
at 1/, it should be today - based on noinal *67 growth and recent in2ation - at
least at 3/ to 4/ .fed watchers say the #ed is 4way beyond the curve50! +n fact, if you
look at the spread between the "-3ill -ate and the 30-8ear "-3ond 8ield, the spread is
at its widest level in the last 90 years .see 1gure below courtesy of 3ridgewater
,ssociates0 indicating that short-ter rates are far too low at this point of the
business cycle, and also given the housing and energy price induced in2ation we have
at present!
"herefore, %r! *reenspan has coe to a dead end street with his onetary policy!
6espite ultra easy onetary policies the bond arket has tubled since %arch of this
year with the result that the housing re1nancing inde' has also collapsed to the
lowest level since %ay 2002! "his by itself ay have soe negative iplications for
() consuption in the ne't few onths, as re1nancing activity allowed hoeowners
to withdraw e:uity fro their hoes, which was then largely spent on consuer
goods and e:uity purchases .see 1gure below courtesy of 3ridgewater ,ssociates0! +n
fact, it will be interesting to see whether the recent strong eployent gains .at least
statistically and super1cially interpreted0 will be able to o;set lower hoe e:uity
withdrawals by hoeowners! %y opinion is that this is unlikely to be the case, and
that consuption will slow down in the ne't few onths & also because 1nancial
arket investors have failed so far this year to ake any oney and are already
likely to sit on soe losses, as they positioned theselves in asset in2ation plays
such as copper, steel, shipping and housing stocks, all of which are already down fro
their %arch highs by 30/ or ore!
<ow, %r! *reenspan has two options! =ither he does pursue his policy of keeping
short-ter interest rates arti1cially low, or increases the in baby steps of >ust 0!2?/
increents and at a slow pace, or he takes soe ore drastic tightening oves
action and increases short-ter rates in 0!?0/ increents right away! +n the 1rst
case, the bond arket will continue to drift lower, as in2ation will suddenly accelerate
eaningfully and in the process also drive down the dollar! ,lternatively, he drives
interest rates up signi1cantly, but then stocks, and hoe prices will ease and have a
negative ipact on consuption, while bond prices and the dollar should be in a
position to rebound! +n short, + a entioning this because unlike what we
e'perienced in 2003, when all asset classes including stocks, coodities, real estate
and bonds rose in concert, we are beginning to see, in 2004, diverging perforances
of asset arkets! =ither bonds and the dollar will continue to tank while stocks,
coodities and hard assets perfor better &at least relatively - or the () dollar and
bonds will hold and even strengthen teporary, while stocks and coodities
perfor relatively poorly! %y bet is that the #ed will ove up interest rates very slowly
for fear to de2ate the various bubbles it itself created and encouraged with its ultra
easy onetary policy! +n particular, the () housing arket would see to be
vulnerable to a sudden sharp #ed #und rise since ore and ore hoes were
purchased this year with ad>ustable-rate ortgages, which carry lower interest rates
.at least now0 than 1'ed rate ortgages and led to hoe price increases in @alifornia
of between 19/ and 33/ year-on-year depending on the counties surveyed!
)till, with interest rates as low as they are today, it is unlikely that even a assive
in>ection of li:uidity into the syste by the #ed will be able to generate new highs for
the year in the various stock and coodity arkets around the world, as the
arkets have begun to have second thought about the long ter conse:uences of %r!
*reenspanAs irresponsible onetary policy, which will, as >ust indicated, certainly lead
to ore in2ation and higher interest rates later in 2004 and in 200?! "here are two
ore reasons to be cautious about e:uity arkets! %utual fund cash positions are at
a historically low level .see 1gure below0! )o, if utual fund in2ows slow down or if
utual funds are faced with net redeptions the deand$supply situation of the
stock arket would not be as favorable as it was over the last 1B onths!
+ ay add that the hoe e:uity withdrawal phenoenon, + referred to above, led not
only to higher consuer spending but also to purchases of e:uities by the household
sector, since not all the oney individuals e'tracted fro their hoes - as a result of
the re1nancing activity - was spent! "herefore, if hoe e:uity withdrawal shrinks it
could also a;ect the deand side of e:uities negatively, which ight e'plain the
recent sudden decline in in2ows into e:uity utual fundsC %oreover, fro the 1gure
below it should be evident that if there were at soe point net redeptions in e:uity
utual funds, these redeptions could only be et by utual funds selling e:uities
.7lease also note how high cash positions were at the onset of the bull arkets after
1D94, 1DB2 and 1DD0!0
Eastly, one group of people, who is usually relatively well infored & the corporate
insiders & have turned decisively less optiistic! +n the 1rst four onths of this year,
() insiders have sold ()F 14 billion worth of stocks copared to >ust ()F 4 billion in
the coparable period in 2003! ,ccording to a study this is the highest insider selling
on record since 1D91 when these insider sales statistics began to be copiled! Gne
ust, therefore, wonder who will be right - the largely uninfored ,erican public
who has piled in into e:uity utual funds at the highest rate since January and
#ebruary of 2000, shortly before the stock arket in the () peaked out .but failed in
2004 to ove the arket uch higher0, or the relatively well infored insiders who
have been duping sharesC + for one, + a betting on the insiders and would,
therefore, use the current rebound in share prices around the world as a selling
opportunity!