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August 08, 2006

A Pre-Fed (not so) Quickie
by Gary Tanashian

Will they or won't they? Wall Street and the mainstream financial media are working a major, hyperbole-driven story; Is the Fed set to pause its long, and thus far ineffectual interest rate hiking regime?

In a financial and economic system driven by greed and myopic hopes of asset appreciation at all costs, it is not surprising to see traders, average Joe's and of course the financial mainstream cheering the end of the cycle. A happy story whereby the Fed has done its job, tamped down inflation and given the reigns back to the markets to freely set asset prices. But there is a decomposing soon-to-be skeleton in the closet; our dear old "Uncle Buck". Bubbleheads who continue to cheer the Fed along a course to dollar debasement are missing two points; 1) The USD is our nation's currency. The medium with which it conducts its exchanges with the rest of the world and 2) It is the Fed's product, it's stock in trade. The Fed, no matter what their verbiage later today, cannot be pleased with the performance of their debt note in the face of an extended rate increase cycle.

Further defining the box the Fed finds itself in, we see the yield spread burrowing further into inversion. This implies the Fed has done its job in cooling certain aspects of the inflation economy as long rates have, in the short term at least, given up the fight against the Fed-controlled short end.

In the last Pre-Fed Quickie I speculated on the possibility that the Fed might decide to make a statement and stomp down inflation expectations. Instead, they went a 1/4 point and the bond market promptly behaved as they wished as 10 year rates declined from their perch above 5.2%. The Fed certainly has some excuses it needs to go on pause today with slowing economic and jobs growth along with legions of what I'll call buyers of last resort beginning to lap up the treasury bond story. Yet there is the dollar, mocked by some and simply ignored by most others, losing ground day by day, week by week and month by month relative to an extended and supposedly beneficial interest rate policy.

The bulls have again worked themselves into a comfort zone, believing that they've got the playbook all figured out. In fact, some measures have them going right back into their greed and hubris driven slumber where all ends up well and in "Greensp....er, Bernanke we trust!". The VIX shows a mostly bearish picture for the broad market after perhaps a few shenanigans based on post-Fed euphoria, if the Fed does indeed pack it in for a while.

Meanwhile, as many readers know, inflation is a currency debasing increase of the aggregate money supply. It is not the backward-looking reading of prices. The uptrend of the last year in 10 year yields is not broken and in fact, I have long speculated on a drop to the 46-48 area. This would constitute the "deflation scare" that will provide the backdrop for future policy. You might guess what form that policy will take.

The Fed has got to be sweating bullets at this point. If they get off the breaks and the curve turns up while the dollar continues to languish in the face of global currencies that are earlier in their rate hike cycles, the possibility of hyperinflation enters the picture. A pretty picture it isn't no matter what happy and convention-steeped stories the mainstream financial services industry may believe.

It is funny, I find myself mentioning hyperinflation for the first time in quite a while. I almost forgot that it was in the playbook and is in fact the most likely final, hail Mary play. First things first however. I believe the Fed has more work to do in reestablishing its inflation-fighting mythology. Therefore, I do not rule out a rate hike today which would allow Bernanke to become his own man and shake off the dovish perception the market has of him.

Gary Tanashian
http://www.biiwii.com/

Disclaimer: biiwii.com does not recommend that any trading or investment positions be taken based on views expressed on this site. If you speculate or invest it is suggested that you consult a financial advisor qualified in your area of interest.

Copyright © 2005-2008 Gary Tanashian

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