US Interest Rates and Inflation - Until is Now: How Fear becomes Risk

By: Paul_Petillo

How high can the markets go I asked last week, running the risk that as soon as a signed that article, it was almost guaranteeing that the markets would fall. How precipitously was unknown. The risk that everyone knew was built into the markets months ago became fear seemingly overnight.

The bond markets, acting as the canary in the coal mine have begun to choke on its own ambivalence. Regarded as the barometer of economic strength and weakness, fixed income has remained somewhat benign as the Dow set records almost daily.

Yet, brewing beneath the surface and lurking in the shadows of the bullish surge in equities, the bond market was beginning to unravel. Housing and the securities that underwrite such all-American endeavors were beginning to lose their luster as far back as January. The Chinese, who seemed as if they would be a never-ending source of financing for our economic activity, have begun to slow their purchases of dollar-based debt.

“What will they do with the bonds they already hold?” investors asked understanding that, if the Chinese so chose, they could begin selling those holdings, now amounting to $1.2 trillion, with an additional $100 billion in mortgage backed securities.

Repeatedly the Chinese have said they would not – and certainly not at a loss. Another possibility surfaced recently offering the markets some indication of their current stance. At the most recent Treasury auction, over $100 billion worth of newly issued debt went almost unnoticed.

Fear has a way of working its way into the psyche of investors. An old Japanese proverb suggests, “ Fear is only as deep as the mind allows”.

Investors, many of who proclaim to be market historians, are constantly looking to the past for telltale markers about future events. With interest rates for the best borrowers still considered to be historically low, where you might ask is this concern coming from and is it warranted.

Investors in the states have mostly ignored the current and assumed interest rate moves by banks in both Europe and Asia . Gradually, the short-term overnight rates offered to the best borrowers have begun to inch up overseas with the same goal in mind that our Fed has: controlling inflation.

Inflation fears are very real but where investors are concerned, they appear to be somewhat overblown. As economies heat-up, the demand for goods increases. Whether those goods are exported or imported or consumed domestically is not important, the cost of producing those products however is. Those costs, more specifically, the raw material costs that go into the production of those goods have been rising steadily and are ultimately passed onto the end consumer.

In developing countries, the fear that wages might actually begin to rise has caused customers to price in possible increases even before the producers do. But these same nations are largely unable to separate the volatile portion of their inflation index from the core measure even as they try to predict future costs.

The Fed, on the other hand excludes the often-fluctuating and highly volatile food and fuel prices from their equation arriving at a number that they feel best reflects the economy.

In established labor markets, the switch to services and away from manufacturing has created a vacuum of sorts. Much of the job growth and wage appreciation that has occurred here in the US in the past several years is result of this shift from tangible manufacturing to industries that cater to creating or servicing wealth.

Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF released a statement in March of this year suggesting that investors will see the global pool of risk diminish as profits from many international companies begin to slow.

He wrote, “In other words, investors have concluded that pricing for risk was too low and that an upward repricing of risk is required.

“How long will this increased market volatility last? Only time will tell. However, one should keep in mind that economic activity and profits around the world are only expected to slow, not to collapse. Should those expectations prove wrong — if recession looms or financial markets continue to take a beating — one can be assured that monetary authorities would likely turn quickly to aggressive easing to revive economies and financial markets around the globe.”

So far, many of these economies have been able to absorb increased fuel and production costs, passing on increased prices without many problems. The fear that wages pressures will force still higher levels of inflation are so far unfounded. But the fear is very real.

In the US , we have seen the steady erosion of buying power even as inflation has, according to the Fed, remained relatively stable. Spending here has become so reliant on debt financing, either from home equity or credit cards, that any sort of pullback by the consumer may foretell some difficult times ahead.

Even if those Treasury rates hit 6% (the ten-year Treasury bond closed at 5.21% on Wednesday), which would push mortgage rates for the best buyers well over 7% (currently at 6.53% for a 30-year mortgage), Bernanke will be unable to begin cutting short-term overnight rates. He too has a certain level of fear with which to deal.

So, where do we go from here? Any economic data on the short-term side could move the markets once again. Another bond sell-off (bond prices move in the opposite direction of the yield) could come with another violent swing in the markets. On Wednesday, following several days of sell-offs, the Dow took back some of its losses.

They may be short-lived however. As long as the markets believe there is a real chance that the Federal Reserve Board chairman Ben Bernanke might actually raise rates rather than cut them, the slightest bit of news will trigger an overreaction. Even the idea that those rates may remained unchanged, now at a year old 5.25% could bring additional selling.

Mr. Bernanke seems comfortable with this short-term speculation. He has offered little in the way of direction and with good reason. His hands are tied. He has made all of the rate increases that American markets see as necessary. Even as the global marketplace catches up with our rate, his options are limited.

The Fed chairman should offer some tangible goals. He was promoted as the plain speaking Fed chairman when he first took the helm. The idea that Mr. Bernanke would give the markets a peek into the Fed's thinking has since deteriorated. He has instead fallen into the same sort of circular rhetoric offered by the previous chairman, Alan Greenspan. Stop with the comfort zones. Tell us where the benchmark should fall.

“The oldest and strongest emotion of mankind is fear,” H. P. Lovecraft wrote “and the oldest and strongest kind of fear is fear of the unknown.”

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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