US Federal Reserve: Hitting Four Birds With One Stone?

``The Federal Reserve's role in prophesying the future course of the economy, the plethora of new indicators brought to the table to maintain the illusion of science, the secrecy of their deliberations, the ambiguous quality of their utterances, the ascetic nature of the chairmen, the elaborate protocol, is possibly idempotent with Delphi.” Victor Niederhoffer, well known Hedge Fund Manager

As we have noted last week, it appears that there had been a marked shift of market leadership from the directional flows of the US equity markets to the actions in the US dollar.

The recent breakdown of the US dollar to generational lows appears to have bolstered segments of the US markets that has been latched to the global outperformance scenario. Evidences seem to corroborate such theory as supported by the vigorous activities in global ex-US asset classes, surging commodity prices and even the record Baltic Dry Bulk index (indicative of strength of global trade).

This week, as the US dollar recovered some of its lost ground, the sluggish US markets had been propped up by a late robust rally last Friday on accounts of a jobs recovery in the US. Unfortunately, US markets appear to have been “lusting” for any tidbits of favorable news in support of the recent gains, such that the mostly government engineered improvements on the job statistics had been construed as “positive”. As we have said before, the adrenalin in today’s markets have been a function of government steroids.

Our belief is that the US FEDERAL RESERVE could be deploying tools to avoid from the furtherance of policy actions to reduce the risks of resurgent inflationary expectations amidst an economic growth downturn, prompted by the deepening housing recession. The attendant and continuing surge in prices of gold, oil, and other commodities, as well as long term treasuries yields have adamantly reinforced such expectations. Moreover, reduced expectations for additional policy actions could cushion the US dollar from a deleterious unwind.

As we have previously noted, US policy makers have repeatedly shown patent sensitivity to the performances of ASSET prices despite their repeated disavowal “to influence asset prices”. Hence, the apparent aim to implicitly bolster asset prices by indirect intervention, such as the recent spate of injection of liquidity, adjustment of policy rules—allows for a wider universe for eligible collateral and allows for a liquidity pass through from banks to their broker dealer subsidiaries and lowering of interest Fed rates. Aside from pent up activities of the Federal Home Loan Banks to fill up the liquidity vacuum.

You can also add to the list the possible manipulation of the recent employment statistics, where most of its gains came from government hiring, aside from the phantom birth/death ratio which accounted for 69% of non-farm payrolls, according to Paul Kasriel of Northern Trust. Thus, the recent breakout of major US benchmarks (Dow Jones Industrials +1.23% week-on-week, S & P 500 +2.02%, Nasdaq +2.92%) reduces the pressures to apply policy actions and this has started to reflect on FED futures as shown in Figure 2.

Figure 2: St. Louis Fed: Fed Rate Cuts Expectations

As we discussed in our Sep17 to 21 edition [see As The Us Dollar Falls, Stagflation Becomes A Reality], for as long as equity prices remain either on consolidation or on the upside the US FEDERAL RESERVE will likely be on a hold. As in the chart, this view has now generated some following as the gap in Fed rate futures (expectations) have narrowed relative to the actual FED policy rates.

In addition, recent communiqués from some Fed officials appear to give some meat to such outlook, this excerpt from Bloomberg, ``It would be a mistake for markets to bake into the cake the assumption of ongoing rate cuts,'' St. Louis President William Poole said today in New York.”

In short, the FED looks to hit an incredible FOUR BIRDS (not two) with one stone… shore up equity prices, lessen the impact of an economic decline, cushion the US dollar from a drastic fall and reduce inflation expectations. It’s quite an arduous rebalancing task, don’t you think?

In our view, there will be a spillage somewhere, as these delicate and fragile balancing acts by a reaction based bureaucratic leadership will most unlikely attain a Utopian climax. Palliative measures are almost always short term remedies, unless they are providential enough. However, given the FED’s predilections towards targeting asset prices, we are likely to see them err to the side of inflation or blowing more bubbles somewhere.

Anyway, over the broader market, the lagging sectors of the US benchmarks which represents internal woes, have played a catch up role last week, dispelling fears of recession risks. However, with the tidal wave of mortgage resets slated from October to the second quarter 2008 or in the coming 6 months or so, we remain skeptical towards the outlook that the US economy would remain impervious to these developments.