Federal Reserve Forced to Choose Between US Dollar and Dow Jones

Daily Reckoning - Now it’s getting interesting. It was a nightmare day on Wall Street on Friday, but not in the way you might think. The nightmare is that whatever the Fed now does, it will cause somebody, somewhere financial pain. More on that in a moment. But first the facts.

The trouble began in New York when the Department of Labor reported that American consumer price inflation had risen at its fastest rate in two years. Officially, consumer prices rose by 0.8% in November in the States. Food and energy were again the main culprits.

You can be pretty sure that if food and energy were rising in Washington, they are probably rising in Sydney…and Melbourne…and Bombay…and Beijing…and everywhere. For one, the supply of paper currencies is growing faster than the supply of food. Secondly, there are 6 billion people competing for the same standard of living and resources. Prices will rise. And they are.

US stocks quickly sussed out the implications and Australian stocks have followed their lead in early trading today. Rising prices in the economy indicate inflation. The Fed, whose official mandate is to fight inflation (price stability) can’t make a very good case for cutting short-term interest rates even further…if inflation is rampaging through the economy like the Hun, laying a torch to everything.

Without more rate cuts, stocks have no momentum. The Dow fell by 1.32% Friday. Investors now fear the rate-cutting may be over. No one has spiked the eggnog yet and the Christmas party is already over!

What can the Fed do? Should it target stock prices, which now respond instantly to changes in interest rate expectations? Or should it target the purchasing power of the dollar?

It reminds us of the choice Carl faces on Neighbours, as of Friday’s episode. We caught the last few minutes of the show while waiting for our double cheeseburger at our favourite takeout place on St. Kilda Road. Carl is caught in a collapsed warehouse, about halfway in the rubble between his son and his daughter, both of whom are calling for his help. Who will he help? We’ll have to wait for today’s episode to find out, but our guess is that everyone will get crushed.

But then, we are making that prediction based on what will happen when the Fed tries to prevent anyone from losing money (both debtors and investors). It’s a fundamentally untenable position, weakening the dollar in the face of the inflation figures. Yet the inter-bank lending market remains paralysed by fear. The Fed is Carl and the warehouse (of its own making) is collapsing around its ears.

It’s a bit of a paradox with respect to gold. The greenback rallies because the inflation figure suggests the Fed won’t be able to cut rates further. Gold falls on a stronger dollar. But it all starts with rising inflation, which ought to favour gold too. Eventually, it will.

The trouble the markets have no is that traditional relationships that used to explain the behaviour of asset prices are breaking down. What else would you expect, though, in a world of floating currency exchange rates? Everything is variable. Nothing is fixed, except, perhaps, the orbits of the planets and professional boxing matches.

Take stocks. Ten years ago, stocks were a lot less interest rate sensitive than they are today. We remember ten years ago reading studies that claimed a change in short-term interest rates didn’t make its way into the real economy for at least six months, and sometimes much longer. Banks changed retail lending rates slowly. And consumers did not take on a lot more debt because it was a quarter point cheaper.

True, interest rate sensitive stocks are always sensitive to policy changes. But that’s more the case in the bond market, where yields and prices were directly affected by changes in rates.

Why is the stock market suddenly on tenterhooks with every change in Fed policy? Why should changes in short-term borrowing rates affect the business prospects of big companies with long-term strategies (we are assuming they have them)?

Maybe it’s because companies have taken on so much leverage and loaded up on interest-rate sensitive assets. With the explosion in credit derivatives and leverage over the last ten years, the entire stock market is now interest-rate sensitive in a way it wasn’t before and, perhaps, has never been. It was the dramatic lowering of interest rates by Alan Greenspan to below zero (in real terms) that led us to where we are today.

The Fed’s current dilemma makes things very interesting. And very dangerous. And also very perverted. We mean perverted in the financial sense.