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Fed in a Corner on Interest Rates

Stock prices wandered lower in early trading after the Labor Department said U.S. labor costs rose by the most in nearly five years and productivity growth slowed in the second quarter. Employment costs for U.S. companies are 4.2% higher than a year ago and gains in worker productivity slowed to 1.8% from 3.2%. This is the lowest reading for productivity gains in the last nine months. The quickest “fix” for companies to reduce their labor costs relative to production is simply to lay-off workers. Higher labor costs and lower productivity is clearly a recipe for higher inflation rates to come. The market’s heightened awareness toward inflationary pressures of record high energy prices combined with rising labor costs is backing the Federal Reserve into the corner on future interest rate increases.

Market participants are begging for interest rate relief from the Fed since the disastrous effects of Hurricane Katrina on the Gulf Coast. Yesterday, Senators and Congressmen from both parties urged the Fed to forgo raising interest rates on September 20th to help consumers and businesses recover from the destruction in the South. Interest rates have in fact moved lower since the hurricane hit as hot money moved into bonds in a flight to safety last week. The 10-year note opened the week with a yield of 4.01% and closed today yielding 4.14%.

The lower rates last week helped to increase activity in real estate lending. The Mortgage Bankers Association said its application index rose 6.8%, with the purchase index higher by 6.1% and refinancing up by 7.7% from the prior week. The thirty-year fixed rate fell nine basis points to 5.64% and one-year ARMS fell seven basis points to 4.81%. The Fed continues to talk of higher rates, but so far bond prices have held up fairly well, keeping rates down. Please remember the Fed has brought attention to “inflated asset prices” and wants to see the “froth” come out of the housing market. Now get this from the Office of Federal Housing Enterprise Oversight; second quarter year-over-year housing price increase was the largest increase in 26 years with a gain of 13.4%. The Fed has recently been targeting asset price inflation, but now they are concerned a decline in home prices could present a risk to the economy. The Fed is boxed in a corner!

Have Your Cake, and Eat it Too!

The interest rate spin in the mainstream financial press is all over the place. Some argue we need to stop the rate increases due to the economic damages created by the storm, while the Fed continues to get more and more bad news on the inflation front. Higher energy prices translate to less disposable income and put inflationary forces into play throughout the entire economy in manufacturing, transportation and service industries. From a year ago, gasoline is higher by 65%, heating oil is 70% higher and natural gas has gone through the roof with a 143% increase from last year. It looks like $3.00 gasoline for your car is going to look cheap compared to what your heating bill is going to look like with the cold Winter Season just a few months away.

The thing that bothers me the most about all the interest rate spin is the effect it is having on stocks and the dollar. Last week in the face of utter destruction, stocks rallied with a bunch of hype the Fed would stop raising interest rates. Today the dollar rallied on speculation the Fed would have to continue raising rates due to increased inflationary pressures. Stocks have continued their rally from last week, even though interest rates are beginning to move higher this week. This week, interest rates don’t matter as much, because supposedly, stocks are higher because oil and gas prices are coming down from their record highs. Go figure!

I suppose I get the best feel for U.S. stock prices when I look to see what happened to shares of Ford today. First, remember that Ford’s debt has been reduced to junk status, then note that Standard and Poor’s credit analysts voiced concerns today about Ford’s ability to service their debts. After S&P analysts voiced their concerns, Ford announced a recall of 3.8 million trucks and SUV’s because of a potential fire problem with the cruise controls. With all the bad news, Ford shares closed higher today! Ford’s sales showed a 6.3% increase in August, but how much did they have to give away with rebates and below-market financing? In my mind, the debt problems and cost of the recall should have trumped the sales gain. Stock prices continue to move higher with bad news all over the place! The Dow added 44 points in today’s trading to close at 10,633, and the NASDAQ posted a modest gain of five points to close at 2,172. The Dow outperformed the NASDAQ with broker upgrades helping the shares of Hewlett-Packard, J.P. Morgan and McDonald’s.

Stock prices seem to move higher no matter what happens in the economy. Bond prices on the other hand, are now reacting to some of the first comments from Fed officials since the hurricane hit shore. The storm hit shore on August 29th and on August 31st Philly Fed President Anthony Santomero said that a “measured pace” of rate increases “will continue to be appropriate.” Fed watchers were anxiously waiting for words from the Chicago Fed Bank President, Michael Moskow this afternoon. In his comments he said rising inflation pressures need to be addressed with “appropriate” increases in interest rates, even though Hurricane Katrina may temporarily slow the rate of growth the rest of this year. He said, “I’m concerned about core inflation running at the upper end of the range…” The Fed went too far by dropping Fed Funds to 1%; now they have a ton of inflation in the pipeline due to too much stimulus over the last two years. They have to try and balance the inflationary stimulus of the past with a slowing economy in the present. So far I’ve played it right this week by shorting Treasury Notes and Bonds, while waiting for the stock market to get a dose of reality!! When I cover my short bond position, I will flip it to short the stock market as we head into the Ides of October!

Fed President Moskow made it clear the Fed will raise rates on September 20. Prior to the hurricane, Fed Fund Futures gave the Fed a 100% probability they will raise 25 basis points on 9/20, but today the futures dropped to a 60% probability the Fed will move higher. As it stands, the market is still pricing-in Fed Funds at 4.0% by the end of the year versus the 3.5% rate we have today. Is the Fed taking the “punch bowl” away at just exactly the wrong time? I believe the Fed is in an all-out battle to defend the paper fiat Federal Reserve Note. Remember, we don’t use dollars any more…dollars are issued by the U.S. Treasury. Ever since the Fed was created in 1913, we have been using Federal Reserve Notes, not dollars! To that point, have you ever wondered where we got that little cliché, “It’s as good as gold!”??? It was the marketing campaign the Federal Reserve used to launch the Federal Reserve Note to replace the dollar…..and guess what….it’s NOT as good as gold!!!...they just want you to think and believe it is as good as gold….never was, never will be!!!

Fed President Moskow said rates will move higher to keep inflation well contained. After reaffirming higher interest rates to come, Mr. Moskow identified four risks to economic growth:

1)  “Rising oil prices may reduce economic growth.”

2)   “So there is also a risk on the inflation front, and the risk is higher now than it was a year ago.”

3)   Moskow said a fall in home prices is a third risk to the economy. (Bloomberg paraphrase)

4)   Among longer-term risks, the deficit in the current account, the widest measure of trade in goods, services and financial transfers, must fall, Moskow said, which means national savings rates must rise. (Bloomberg paraphrase with my emphasis in bold.)

Two years ago Fed governors were out telling everyone to buy SUV’s to support our economy; now we need to increase our savings and cut spending. The CURRENT ACCOUNT is the REAL PROBLEM!! We have Federal budget deficits as far as the eye can see and trade deficits that keep getting bigger and bigger. We are spending over $100 billion in Iraq, and hurricane damages are expected to be DOUBLE the cost of our Iraqi Adventure. The powers that be are trying to spin the dollar (FRN) higher with the interest rate differential over other major currencies, but the current account is far more important than interest rates to determine currency values. Just look at the yen appreciation versus the dollar since the beginning of 2002 with interest rates below 1%. Japan’s federal budget is in surplus and they have a positive trade balance. In the U.S., we import goodies and export borrowed money.

In the short-term it appears the “Banker’s” privately owned Federal Reserve is more determined to defend their Federal Reserve Notes as the reserve currency of the world. Short-term growth will be sacrificed to provide temporary life support to the dying dollar. We will need some DRAMATIC adjustments in currency values to reduce American consumption and increase savings to get our negative trade balance to a manageable level. We need to devalue the dollar versus all global currencies, but China won’t let us do it with the current peg to the dollar. Our Congressmen were prepared to hit China with a 27.5% import tariff if they didn’t revalue the yuan. China adjusted the yuan about 2% higher…a far cry from 27.5%! Currency wars and geopolitical tensions are here to stay. I’m afraid the Fed has created their own problems with Easy Al at the monetary reins creating too much liquidity with the lowest cost of money in half a century. They have created a monster with over-inflated asset prices in stocks, bonds and real estate. The excesses are now spilling over to ignite consumer inflation, a big concern of the Fed.

With all of the recovery activities in the South, it reminded me of a question I once asked a good friend of mine from Georgia. My buddy frequently used the expression, “Y’all.” He used it quite gracefully when addressing one person or a group of people. I kept thinkin’ that if “y’all” could mean one person, there must be a plural version of “y’all,” so I asked him, What is the plural of “y’all?” He immediately said, “Well that’s easy Mike, it’s “All y’all”…..I just knew there was some logic to it; I just needed a friend from Georgia to clear it up for me! My heart and prayers still go out to the victims of the storm!

All y’all that read me much know I’m watching my silver trade very closely at the moment. It sure looks like we’ve seen the bottom after the recent shakeout to $6.75. I held strong through the shakeout and added more contracts at the lower levels. Now it’s all about Ride-‘em Cowboy as we move through the trade on December Silver! I will sell the spikes and buy the pullbacks while remaining net long. I have mentioned Ted Butler’s commentary on silver frequently in my WrapUps. It would be redundant for me to express my opinions, then for you to read Mr. Butler, so I defer the commentary on silver to the expert, Mr. Ted Butler with this link to Investment Rarities.

The markets are going to take a long time to figure out the impact from the storm damages. Our productive capacity has clearly taken a big blow. GDP for the second half could easily come in below 3% growth. Put the sub-3% growth up against an inflation rate of 3%, and we really don’t have any growth at all. The Fed is stuck in the hard spot of holding up asset prices, containing inflation, and defending their Federal Reserve Note as the currency of last resort. Lots to think about!!

Have a Great Evening!

Mike Hartman

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