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END OF CYCLE: COLLISION COURSE

Looking back at the history of Fed tightening cycles there is one giant and ever-recurring event —- the late-stage “Crack-Up Boom”. Put another way, it seems that on this occasion—as in others in the past—history has at least one important lesson to recount. Namely that Fed tightening cycles normally do not end with a “whimper”. Instead, more often than not, they end with a “bang”. So we find that 2006 could potentially be a case of history repeating itself.

The Bridge Too Far
Looking back at the lessons of past tightening cycles, we see that more often than not, the Fed has crossed the ‘bridge too far” with one interest rate hike too many. In every single case financial crisis followed. Anyone remember the Penn Central Railroad Crisis of 1970, Franklin National Bank in 1974, Mexico 1981-1982, Continental Illinois May 1984, Black Monday 1987, The Savings and Loan Crisis of 1990, Orange County and Mexico (again) in 1994, Asian Contagion—Pac Rim—Russia and LTCM in 1998, The Tech Bubble of 2000- NASDAQ? In every case, these events followed a long string of Federal Reserve interest rate hikes.

Looking at the current cycle we find that since early 2004 the Fed has been hiking rates on the Fed Funds from a low of 1% to the current rate of 4.75%. Most economists now anticipate a further move to 5% in May and possibly even 5.25% in June. Importantly, expectations have been running high since last December that the “Fed” is almost done with its long series of rate hikes. Yet as can be seen in the table below in the 11 prior “tightening cycles” seen since 1946, 9 out of 11 times the U.S. economy has ended up in recession and in a “hard landing”. This suggests, once again, this marked tendency on behalf of the Fed to “overdo it with too many hikes”. What’s more, in the eight instances since 1929 when the Fed has raised interest rates by more than 175 basis points, the stock market—as measured by the S&P 500—was down 12 months later, 6 out of 8 times with the average loss, a decline measuring 7.50%.

Where Are We Today?
With this past history in mind, it would seem like a good idea to recall several “facts” about the current cycle. To begin with, we have now seen 15 “¼” point hikes—the most of any prior cycle. Those hikes already embody an increase in the overnight rate of 375 basis points (and counting). What’s more, the immediate path head seems strewn with potential stumbling blocks as the markets appear to be hoping—as evidenced by Tuesday's nearly 200-point Dow advance—that an end to Fed tightening is finally at hand. However, it is equally clear for recent Fed meetings that the Reserve Board is keenly focused on Labor Market conditions as perhaps the most important driver in its decision-making process in the weeks and months ahead. From an economic point of view, this is highly understandable as Labor Input Costs have roughly 7 times the impact on total business costs as commodity prices, which are relatively small by comparison—today’s high prices non-withstanding.

For the Fed, the battleground for “containing” inflation is the Labor Market. In this regard, I believe there is a very high risk that capital markets could suffer a “scare” regarding the outlook for Fed policy in the weeks ahead. While it is not widely discussed, for the last few years the U.S. government has employed a new statistical model it uses in generating its Employment and Payroll Data. This model, known as the Birth-Death Model is based roughly on past cycles and uses past employment cycles to make an educated guess at hiring trends for this cycle. Thus, unbeknownst to the majority of the investing public, when the Non-Farm payrolls are released each month, there is often a rather large contribution of Jobs Created, which emanate directly from this model.

Employment Numbers
In the table below I show the “jobs created” each month for the time period that the model has been in use going back to 2001. Notice that every January we see a large negative number, which reflects the Bureau of Labor Statistics' attempt at reconciling the model with reality or what could be more loosely termed “purely phantom jobs” with potentially “bona fides phantom jobs”. Put another way, every January we find out—to some modest degree—just how much of the fictionalized hiring seen in the prior year was purely bogus.

Continuing with the table above, we see a peculiar cyclicality at work, which is really important to understand. Between March and June of each year, the good old boys at the BLS go on a “job creation” bender and guess what? They do it every year. That’s right! In those four months they figure that’s when all of the hiring happens each and every year. After that, as you see in the bar chart below which plots the monthly “averages” for each of the last five years, it's all downhill with very little phantom job creation in the latter half of the year.

So now, why is this important? Well, it is important because the March jobs report was 135,000 jobs created via the Birth-Death Model, which was 63% of the report payroll increase for the month of March or a total of 211,000 new jobs. So looking ahead, we see that both April and May have a strong tendency to show even better job creation. Keeping in mind for a moment that is also an election year, with very important mid-term elections. Would it really surprise anyone if this year's “job creation” was especially robust? In my view, it’s a pretty good bet that we will see strong numbers and guess what else — a rosy economic outlook.

Employment Cost Index
In addition to the potentially stronger-than-expected job creation numbers that we will mostly encounter in the weeks ahead, it is also very important to focus on the Employment Cost Index over the next three months. This number is very likely to be a “big deal” and could have a major impact on both the stock market and the Precious Metals. As I have alluded to in the recent past, it is my view that both the metals and the stock market are riding in the same boat currently with both markets hoping for an end to Fed rate hikes.

If one steps back and looks at the long-term relationship between Average Hourly Earnings and the Employment Cost Index, a very strong correlation is present. In fact, the correlation is positively striking with Average Hourly Earnings leading changes in the Employment Cost Index by several months to a year. Importantly, over the balance of the last two years, Average Hourly Earnings has surged from an annual rate of change low of 1.60% to a current reading near 3.4%.

Even more important, the Employment Cost Index has not yet turned up for this particular cycle, which is showing a serious lag. In the past, when big differentials like this have emerged, the Employment Cost Index has had a marked tendency to spike sharply to the upside and play “catch up”. This “catch up” behavior was seen in late 2002 and in mid-2000.

How serious a problem for the markets could a strong surge in the ECI become? In my view, since the Fed places a great deal of weight on this particular indicator, the odds are that a strong reading on this gauge could easily push the Fed toward extending its present string of rates hikes well beyond 5%.

Real Short-Term Rates
On the next chart, I show the very long-term view of “Real” (Inflation Adjusted) Short Term Rates. Notice that the long-term average is just around 2%, which could be the unspoken target for a Fed seeking the “Neutral” or “Normalize” Rate. With CPI currently running at 3.60% and the Fed Funds Rate at 4.75%, I could easily see the Fed headed toward 5 ¼% or even 5 ½% in coming months— that's if we assume that CPI heads down toward 3.25%, a 5.25% Fed Funds less 3.25% CPI would achieve a 2% Normalized Rate.

In my view, judging by the stock market's nearly 200-point advance on Tuesday—in hopes of an end to Fed tightening—and the Gold market's nearly $45 dollar equivalent run, odds of a big disappointment could be at hand if upcoming labor market reports head into a period of seasonal and statistical strength. For the average investor, where the latter phases of the Fed cycle tend to end with financial “events”, the current time would seem to be a good time to be “dialing down the risk” and raising some cash.

That's all for now,

Frank Barbera

Copyright © 2006 All rights reserved. Frank Barbera, C.M.T. Investment Analyst, Manager Commentary Archive

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