In the land of textbook economics, a central bank takes away the proverbial punchbowl when the party threatens to spin out of control. The removal convinces the partiers to cool their jets. In time, the central bank rewards everyone by returning the punchbowl, thereby planting the seeds to launch a cycle anew.
Nothing’s quite so simple in 2006. In fact, much of what professors like to teach in economics 101 is up for debate. Take the punchbowl, everybody’s favorite central-banking metaphor for easy money. This basin of liquidity injection was delivered in earnest a few years back. Predictably, the presence of cash sloshing around the system ignited bull markets far and wide. Evidence can be found everywhere, with the repercussions continuing to the present. It’s hard not to find an asset class that’s not running skyward these days. As a sampling, here’s a slice of what’s unfolded so far in 2006, through yesterday:
Large-Cap Stocks: +5.24% (S&P 500)
Small-Cap Stocks: + 14.68% (Russell 2000)
REITs: 10.03% (Morgan Stanley REIT)
Commodities: +8.17% (Oppenheimer Real Asset Fund)
10-year Treasury: +1.12% (10 Year Constant Maturity Treasury)
Junk bonds: +2.98% (ML US High Yield Master II Index)
The Federal Reserve is of course currently engaged in a gentle effort to remove the punchbowl with minimal fuss. In fact, one might argue that the Fed has been attempting to elevate interest rates but without affecting investor perceptions, which is a bit like trying to trying to discipline Rover and hope that he still retains his old habits. But even the central bank’s subtle effort may be nearing an end, if yesterday’s release of minutes from the Fed’s March 27-28 FOMC meeting are an indication. “Most members thought that the end of the tightening process was likely to be near…” the minutes advised.
San Francisco Federal Reserve president Janet Yellen brought the thinking of the March minutes into the here and now in a speech yesterday by voicing concerns of “the policy tightening going too far,” via TheStreet.com.
Cycles, it seems, aren’t quite what they used to be with respect to timing. Consider that with optimism finding fertile ground in a broad array of assets, the stewards of monetary strategy seem to be thinking that it’s time to bring the punchbowl back. As you might expect, the mere hint of that party favor brought cheers to the stock market: the S&P 500 soared yesterday, jumping 1.74% on Tuesday.
Meanwhile, the bond market registered its own brand of approval, cutting the yield on the 10-year Treasury Note down below 5.0%, and for the moment putting the hawks back on the defensive just a few days after it seemed the fixed-income set had reordered its thinking.
The reaction in the forex market was no surprise either, although it unfolded with a broad based selling of the dollar, which has fallen to its lowest level since January, based on the U.S. Dollar Index. The fear is that with rates hikes behind us, the yield premium that the dollar’s enjoyed recently will continue to fade. Indeed, while the Fed toys with the idea of ceasing to tighten, Europe and Japan are increasingly inclined to raise rates, making the euro and yen incrementally more attractive.
The primary question on American soil is whether it’s time to stimulate the economy or continue laying the groundwork for fighting any future inflation. The ongoing debate about whether core or topline inflation measures are the true gauges of pricing pressures is back in the driver’s seat. The debate is very much present in the FOMC meetings, as the latest release documents. Consider the range of commentary in the March minutes on the topic of inflation:
* …meeting participants generally remained concerned about the risk that possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, could add to inflation pressures.
* Preliminary survey measures of short-term inflation expectations in March edged up, but longer-term measures remained steady.
* Core inflation had stayed relatively low in recent months, and longer-term inflation expectations had remained contained. Nevertheless, the Committee noted that possible increases in resource utilization as well as elevated energy prices had the potential to add to inflation pressures.
* Core PCE inflation was expected to move slightly higher in 2006 because of cost pressures induced by high energy and import prices and to step back down in 2007 as these cost pressures were anticipated to abate.
* …productivity growth, moderate increases in compensation, contained inflation expectations, and international competition were helping to restrain unit labor costs and price pressures. Nonetheless, meeting participants generally remained concerned about the risk that possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, could add to inflation pressures.
The Fed, in case you didn’t notice, is struggling to find context in 2006. But if the signals are ambiguous, the stakes remain high, and climbing. Indeed, commodity prices are high because the global economy is growing at a healthy clip. That’s feeding into investors’ appetite for risk, an appetite that seems to have gone up a notch after yesterday’s release of Fed minutes.
But the strategically minded investor knows that asset allocation is a discipline for a reason, namely: asset classes exhibit varying degrees of correlation, which is to say they deliver a range of results in any given snapshot. You wouldn’t know it by looking at returns so far in 2006, a year when risk across the board continues to be satisfied with positive performance. That can’t last, but for the moment there are many who are acting as though it will.