| "We do not succeed in changing things according to our desire, but gradually our desire changes." |
| -- Marcel Proust |
T'S BEEN A LITTLE OVER A YEAR NOW SINCE the Federal Reserve (Motto: "Shoot 'em all first, sort 'em out later.") started raising interest rates. Late last spring the economic tea leaves stirred them to action in an effort to ward off what they perceived to be an impending wave of inflation.
Despite indications to the contrary, the overheating economy became a fact. CNBC's talking heads fretted about it everyday. Fed governors made speeches around the country justifying their hawkish stance. Bond investors saw rates rise and the value of their holdings decline. Even stockholders hoped the economy would slow down.
Thirteen months and numerous increases later, economic statistics are starting to show the effects. Housing starts are down, unemployment is drifting up, and CPI and PPI remain under control. A growing consensus holds that this round of rate increases is about over.
So everyone's finally getting what they wished for, that's good, right? Well, not exactly.
Good for Bonds
A slowing economy is good for bonds. Bondholders (Motto: "Bad news is good news.") are particularly susceptible to changes in interest rates. When the Fed sees the economy slowing, they stop raising rates. Stable or falling rates add to the principal value of bonds, so if the Fed's done, bonds may have already hit their low point.|
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 Source: Baseline |
Recent yields appear to bear this out. After spiking up earlier this year, the 30-year Treasury bond has traded in the 5.90-6.10% range while the ten-year bond has been slightly higher at 6.00-6.25%. If the economy truly is slowing, this may be the high end of this cycle.
It may also be an opportunity for asset allocators to move into bonds. Like any investment, you want to buy low and sell high. If yields are at their peak, prices are at their lows, making bonds relatively attractive.
Of course the yield curve remains inverted with the longer yields below the shorter yields. This is typically a sign of an impending recession. While the Treasury's buyback of longer maturity bonds may have something to do with this, you can't automatically assume previous history won't repeat itself. Actually a recession goes hand in hand with a slowing economy -- both are traditionally good for bonds.
Unintended Consequences
But then again, recessions aren't good for much else. We're a little more worried than most about the possibility of recession because again we're concerned about history repeating itself.You see, bull markets and economic expansions don't end because they run out of steam, or even because of increasing inflation. No, they traditionally end because the Fed overreacts. Usually when they start tightening credit, they go too far and send the economy into recession. They've probably done it again.
As we've argued before, there's a 9-12 month lag between Fed action and its effect on the economy. At this point, the economy already appears to be slowing with only the effects of the first 1/4-1/2 point increase. Odds are, when the rest filters through, we'll be on the brink of a recession.
At this point, neither the Consumer Price Index (CPI) nor Producer Price Index (PPI) show any signs of accelerating inflation. Sure, they're higher than they were last year or the year before that, but those years were well below average. Wages currently pose little threat of starting the inflationary spiral. Aside from oil, commodities show little sign of inflation.
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 Source: Baseline |
Even oil's Gulf War price levels needn't be a major concern. Originally prices spiked when OPEC cut production to raise their revenues. Later when they attempted to ease the squeeze, prices stayed stubbornly high. Our domestic oil refiners can take most of the blame for this. Knowing that OPEC was increasing production and prices would soon be falling, they held off replenishing their dwindling stocks, hoping to do so at lower costs. The longer they waited, the lower their supplies, and the greater the concern over falling stockpiles. This, in turn, keeps prices high.
But this is a temporary problem. Eventually refiners will replenish their reserves and/or OPEC will increase supply. Look for the U.S. to put some pressure on our OPEC allies (Motto: "Always there when they need us.") to step up production.
In the meantime, higher oil prices help the Fed slow the economy since they serve as a tax on domestic consumers and producers. The higher cost of gasoline and related products will help curb consumer spending. Manufacturers will pay higher prices for production inputs, but will have a difficult time passing this through via higher prices. As a result, they'll cut back production, slowing the economy.
Oddly enough, inflation may rise before it ultimately begins to fall. Why? Because it always does when the Fed raises rates -- especially as drastically as this time.
Here's how it works: Inflation is commonly defined as too many dollars 
chasing too few goods. When the economy does begin to slow, companies are forced to cut back on production, reducing the number of goods available in the market. The dollars in consumers' hands remain the same but the goods available for purchase decline. All of a sudden, there's too many dollars chasing too few goods. You have higher inflation. Let's hope the overly zealous Fed realizes this and doesn't take it as an excuse to tighten even more.
On a brighter note, the Fed's overreaction may have some unintended positive effects. By the time most "commentators" realize they've overshot the mark, it'll be election time. If you recall, Bill Clinton (Motto: "I'm a hands-on president.") was able to usurp the White House in 1992, the last time the economy flirted with recession. He blamed President Bush for the actual and potential problems, and used this to his benefit.
In reality, Bush had nothing to do with the economic state in 1992 just as Clinton has nothing to do with it this year. But if the electorate (Motto: "Collectively we're as dumb as a box of rocks.") blames the current administration for a potential recession, we'll at least be saved from four years of Al Gore (Motto: "As interesting as a wet dishrag with almost as many original thoughts.").
A Problem and an Opportunity
Perhaps the biggest dupes in all this have been the stock investors. All along they've cheered the Fed's efforts to curb the economy. Why? Because they bought the argument that a rapidly growing economy must automatically lead to inflation, ultimately reducing corporate profits and cutting stock returns.Well guess what? Their wish came true. The Fed has succeeded in slowing the economy, but guess what that means? As production costs rise and consumers curtail spending, companies sell less product, and what they do manage to sell comes with a smaller margin. Lower sales, margins, and profits hurt stock performance. Investors get what they wanted -- which turns out to be exactly what they didn't want.
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 Source: Baseline |
We've said it before (July 1999 True Facts) and we'll say it again, Economic growth doesn't cause inflation, but rather economic growth occurs under conditions of price stability. The economy was rapidly expanding because inflation was low and prices were stable. To think a growing economy causes inflation is to believe stable prices cause inflation. It's a ridiculous contention, but it's fueled debate and Fed action for over a year. Now we have to live with the consequences.
There is, however, a positive side to all of this. As the previous rate increases have had their effects, the equity market has retreated from the frothy levels of March. The correction/bear market not only hit incredibly valued dot.coms, but real companies as well. And that's were an opportunity lies.
Quality companies like Cisco Systems, Chase Manhattan, and Solectron have come down to prices not seen in over a year. With prices on companies like these this low, this is an opportunity to raise the quality of your portfolio. You don't need to speculate on the latest IPO or supposedly hot Internet stock when you can add quality companies at bargain prices.
If you don't do it now, you'll be kicking yourself in the fall, wishing you had. This buying opportunity may not be what you wished for, but it's what you got. Oh, and in the future, be careful what you wish for.
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