May 10, 2006
ONE MORE HIKE?
The Federal Reserve's FOMC meets today, and it's widely expected that interest rates will again rise by 25 basis points, bringing Fed funds to 5.0%. That's a prediction hardly worth the name, as the Fed's been dispensing 25-basis-point hikes methodically since June 2004. Indeed, the Fed funds futures contract for May is priced for 5.0%, and hardly anybody expects a surprise.
What's different this time around is that Fed Chairman Bernanke has recently suggested that a pause in rate hikes may be coming. But given the ensuing debate that Bernanke's advisory triggered on the matter of his inflation-fighting credentials, some wonder if perhaps Ben may rethink his inclination to put tightening on a hiatus, temporary or otherwise.
A bit of uncertainty, in short, hangs over the policy outlook for the Fed for the first time in recent memory. Perhaps it's unavoidable, given the ample dose of conflicting signals coming from the economy and the capital markets on the all-important question of whether GDP is or isn't slowing more than a little. But no matter the cause, transparency has dropped down a notch or two for the Fed. For the moment, the central-bank transparency that Bernanke has long espoused as an academic looks to be on the defensive now that he's running the money machine in Washington. That may change in the future, but in the here and now there's a bull market in guessing where monetary policy's headed, and that's probably not what the Fed wants.
Or is it? Bernanke himself confessed in March that "the implications for monetary policy of the recent behavior of long-term yields are not at all clear-cut." No one can accuse him of exaggerating, considering the current state of puzzlement over the future of Fed policy.
If anxiety is the obvious reaction to a central bank that seems to be struggling with what to do next you wouldn't know it by looking at the stock market. The S&P 500 has climbed by 2.4% in the last four weeks and is up a tidy 6.8% so far this year, through yesterday's close. Meanwhile, small cap stocks continue to deliver even better gains. The Morningstar Small Cap Index is up 3.5% in the past four weeks, and year-to-date it's increased by 15.9%. If this keeps up, Bernanke's rhetorical ramblings will deliver one heck of a bull run by Christmas.
In fact, it's the bond market that's showing increasing signs of worry. The Lehman Brothers Aggregate Bond Index is flat for the past four weeks, and down by 1% for the year so far. Although the recent run-up in the 10-year Treasury yield has slowed this week, it's still holding above 5.1%, and in fact looks set to keep rising in the coming weeks and months, to judge by the momentum displayed of late.
Meanwhile, Bernanke is being warned by the gold market that business as usual isn't acceptable, to judge by the Fed chairman's recent manner of discussion. Gold touched $700 an ounce for the first time since the Jurassic period. That translates into a 35% rise so far this year for the precious metal. It's getting harder for the Fed to shrug off this barometer, which is first and foremost a reflection on the growing doubts about the dollar as a store of value. Does this mean the Fed will feel compelled to dump some of its massive gold holdings on the market to trim the metal's rise, if only temporary?
To be sure, some of gold's run comes from various geopolitical jitters, starting with the ongoing quarrel with Iran and the West over the former's nuclear ambitions. Such tensions, along with the usual worries over America's trade and budget deficits, are conspiring to drive down the dollar to depths not seen since May of 2005. If nothing else, the dollar's plunge lends legitimacy to gold's rise.
The stock market may be unconcerned with all this, but there's a decent chance that the nail-biting that's descended on the fixed-income set will migrate over to equities in the near future. But first Mr. Market will take a look at the FOMC statement scheduled for publication this afternoon. Rest assured that traders and economists the world over will be giving the statement a razor-sharp scrutiny in search of clues about what the Fed's thinking for the future. It promises to be wasted energy. The central bank is making it up as it goes along at the moment.
There's a lot of tension in the air, and deconstructing Fed statements is no cure for what ails. When the stock market throws in the towel, then the fun will really begin.
Posted by jp at May 10, 2006 9:47 AM
Not the price, the yield. Yeilds rise inversely to price, e.g. demand for bonds is dropping for investors (though not for foreign governments wishing to prop up the dollar relative to their own currencies, to keep joe sixpack consuming happily)
Posted by: anon at May 11, 2006 10:15 AM
The dollar tanks and the price of bonds goes... up? What currency do they think we are going to use to pay the bonds back?
Posted by: anon at May 10, 2006 12:16 PM