On my way back to Austin I attended a conference in Dallas that had a guest speaker from Investors Business Daily, Fred Richards, who was a very entertaining, curmudgeonly septuagenarian. He is extremely bearish on the market and bullish on gold. Here are some key points:
- Every time since 1914 when the Fed has paused its rate hikes, it was done for the time being. This time will be the exception.
- Fred expects the Fed rate to rise to as much as 8% within a year. I don't agree with the magnitude, but our sentiments are similar. This is a very big deal, and I'll go into more details below.
- Overall Fred feels like the government is practicing "Enron Accounting".
- He also believes there's a fair chance that Ford will declare Chapter 11 and GM will follow shortly, sending the markets in a tailspin.
The Fed has stopped announcing its M3 metric of monetary liquidity, playing with numbers just as they have done recently with inflation measures in order to mask the work they're doing behind the scenes. This isn't necessarily a bad thing since the Fed has a major role in preventing needless market panic, and perhaps they are trying to hide just how bad things are until they get a handle on what they can do about it. Some things such as the housing market are so outside of the Fed's control right now that they may decide to sacrifice it in favor of reducing inflation by raising rates much higher. But the market sentiment shows that people are still not ready to accept the reality of our current situation.
Though the Fed paused its rate hikes, it is still increasing liquidity while other nations are reducing liquidity (e.g. Bank of Japan) and raising interest rates. Increasing liquidity means that the Fed is dumping dollars onto the market, effectively lowering the value of each person's dollar. A more direct effect is that the dollar remains undervalued compared to its previous stance against the Euro, Yen, etc. While this helps reduce our trace deficit by attracting more international interest in purchasing American goods, it also lowers the value of the tremendous treasuries (US debt) held by foreign investors and foreign banks. Fred also notes that the "risk spread" in treasuries between short-term and long-term rates is very low, indicating that investors are as uncertain about the near future as they are about the long-term prospects of the economy. In order to combat inflation without damaging the economy too heavily, I agree with Fred that the Fed appears to be maneuvering towards a policy of increasing liquidity and increasing interest rates, but after this pause I'm less certain of the Fed's intentions.
Foreign banks will likely start to dump their treasuries unless they see further incentives to hold them. Politics still plays heavily into this however, and countries like China have massive holdings of US treasuries to help stabilize their currency but also to garner political favor with the US (and offset the painful trade deficit). There's no easy strategy here. But overall the increasing liquidity may also require a significant rate hike to attract more buyers of US debt. And without any leadership in the White House to reduce our debt and trade deficit, we become increasingly at the economic mercy of other countries. Fred pointed out that the Euro is the basis currency for almost as much international trade as the Dollar (both of which outpace the Yen slightly). And while the Dollar is still the basis for most oil trading, OPEC has diminishing incentive to maintain this.
Returning to monetary policy, Fred sees a very high risk that the Dollar will lose much of its value against other currencies. This may be intentional from the Fed's increasing liquidity, or unintentional due to massive liquidation of dollar assets from disinterested foreign banks and investors. The way to fight this is with strong rate hikes, which will pummel the American housing market and wash through the rest of our economy. But the alternative with keeping rates low and reducing liquidity will also hurt the economy, with high inflation and a low risk-spread on Treasuries causing worried investors to sit on their assets and not reinvest in the market (further reducing liquidity).
Some believe that our economy needs a cold shower to recover from our hangover of partying too hard for the past 6 years. The bursting tech bubble was combating by Alan Greenspan with record-low interest rates, driving money sideways into the housing market and causing a bubble there. That didn't solve our problems, but merely shifted them to a different asset class. A recession can be like a controlled burn, clearing out the "underbrush" of waste, mismanaged money and excessive consumer spending; at this point it may be a necessity. The question is just one of timing: is Bernanke maintaining the status quo until after elections?
While I keep hearing shouts that "cash is king", a weak stance on inflation will turn much attention towards commodities (gold, platinum, etcetera). A stronger stance on inflation may still cause dollar devaluation, again drawing attention to commodities. Fred is very, very bullish on gold and copper. I plan to research these more and I will post my findings soon.