HEN ALL NECESSARY CONDITIONS are favorable for the development of a storm, meteorologists (at least those on TV) refer to the resulting tempest as the "perfect storm". When this occurs, the winds are stronger, the percipitation more copious, and the overall storm more intense than your average run of the mill disturbance.

Adapting that logic, one could also say that for the past two years, there's been a "perfect storm" in the U.S. economy. In this case, it isn't a destructive storm, but rather one that should be extremely conducive for economic growth. Just consider, monetary policy is possibly as lax as it's  ever been, fiscal policy has just delivered a massive tax cut, inflation is low, inventories are down, and exchange rates favor domestic exports.

It took awhile, but by the end of 2003 the effects were clearly rippling through the economy. Third quarter GDP grew at a blistering 8.2% while the November ISM (formerly Purchasing Managers') index and third quarter productivity were at twenty year highs. In the meantime, inflation -- at least at the consumer level -- remained below 2%.

There's no doubt the economy picked up in 2003, but now the question becomes one of sustainability. How long can these favorable conditions persist?

When the Party's Over

As with any party, not all guests are equally important. Also as is often the case, those that command the most attention aren't necessarily the most important. Consider, for example, commodity prices. Bears point to them -- particularly gold -- as an indication of problems ahead.

Rising commodity prices often signal inflation at the producer level which in turn, is then passed through to consumers. A spike in inflation can be a precursor to higher interest rates and an economic slowdown.

GOLD INDEX (XAU)

Source: A-T Financial Gold has traditionally provided diversification to an equity portfolio since it is inversely correlated with stocks. It hit its most recent bottom in 2000, just as stocks were peaking. As equities fell into the bear market, gold picked up momentum into early 2003. At that point investors began to pile into gold as a hedge against the falling dollar sending the metal well above its long-term trend line.

Gold has certainly taken off since bottoming in 2000. It's often used by investors to diversify their portfolios as its defensive nature makes it an almost perfect foil for equities. That's exactly what happened in the recent bear market when stocks fell and gold established a long-term uptrend.

But as stocks continued climbing in late 2003, gold broke out to a 20-year high. Not only does it help push up the overall CRB Commodity Index, it may be raising inflationary red flags.

Gold, however, is something of a red herring when it comes to gauging the economy. The recent spike is more of an effect rather than a cause of economic fundamentals.

Investors typically view gold as a hedge against both inflation and the falling dollar. Inflation has been tame, but the dollar has been tumbling. By the end of 2003, it was near its all-time low against the euro. Of course the European common currency doesn't have a long trading history, but the dollar was also surprisingly weak against the Japanese yen, despite Japan's ongoing deflation.

The dollar has suffered versus other currencies for two reasons: interest rates and fiscal policy. The Fed appears committed to keeping rates low in an effort to avoid choking off the fledgling recovery.

EURO vs. DOLLAR (XEN)

Source: A-T Financial After struggling against the dollar in 2001 and the first part of 2002, the euro has steadily moved to new highs and conversely, the dollar has fallen to new lows.

In the meantime, some of the U.S.'s major trading partners have already begun raising rates. As a result, investors have pulled funds out of the U.S. to reap higher returns in other countries. This reduces the demand for and value of the dollar.

Further reducing dollar demand relative to other currencies are the U.S. trade and budget deficits. Both weigh on the dollar and have been encouraged by recent fiscal policy.

So investors have sought gold as a hedge against the falling dollar. As demand for gold has gone up, so has its price. This, and the weak dollar, are the results of monetary and fiscal policy, nothing more.

Gold, and other commodities to a lesser extent, have drifted up reflecting an increased demand in the factors of production. At this stage in the recovery, a little inflation at the producer level is a good thing.

Party Poopers

The Fed has always had a reputation as party poopers. As the quote at the top of this page from former Fed Chairman William McChesney Martin alludes, the Fed -- especially the Greenspan Fed -- has always been quick to raise rates when the economy begins to show even the slightest signs of overheating.

In most instances, the Fed overshoots in both raising and lower rates. Monetary hawks have already been warning that rates have been too low for too long, and to keep them at this level only tempts a greater bout of inflation.

The Fed is steadfastly holding to the claim that there's still little threat of inflation. While most economists weren't expecting an increase at the most recent FOMC meetings, they have clung to every word in the Fed's statements. As recently as the December meeting, the Fed was still saying rates could remain a present levels for a considerable period of time.

All else being equal, a low rate environment would be good for bonds, yet fixed income investors are on edge. The problem stems from the Fed's mixed signals. According to former Fed Governor Lyle Gramley, "They're saying they'll keep interest rates low for a long period; that's good for bonds. But the reason they want to do that is because they want to stop inflation from going down, and that's bad for bonds."

Bond investors are understandably suspicious. They feel they were duped last year when the Fed indicated it would augment its easing policy by purchasing Treasury Bonds in the open market. Just as investors began positioning their portfolios in anticipation, the Fed reversed course, saying the economy was showing signs of improvement so there was no longer any need for "unconventional" monetary policy.

10-YEAR TREASURY YIELD

Data Source: Baseline The 10-Year Treasury Note yield drifted down for the first five months of the year, then spiked in June when the Fed acknowledged that the economy was strengthening. After peaking in early mid-August, the yield stabilized in a range bounded by 4.15 - 4.45%.

If the Fed didn't see the need for additional easing and if the economy was truly turning, could rate increases be far behind? Again in anticipation, investors locked in profits by selling Treasuries, sending yields up one percent in about a month.

The sudden jump in rates stalled the stock rally, too. Investors found the higher yields available on Treasuries as a viable alternative to stocks. Equity investors worried that higher rates might stifle the nascent recovery, sending earnings and share prices back down.

At the time, we advised investors not to panic since rising rates from the current 40-year lows were inevitable. Higher rates needn't roil the market as long as they were gradual and orderly. Sure enough, as soon as rates stabilized around 4.25% on the 10-year note, bond investors came back into the market and stocks resumed climbing.

Which brings us back to the the point: The Fed must act carefully. Even with the yield on the benchmark Treasury at 4.25%, it's still historically low. As the economy recovers, the Fed will feel more pressure to begin tightening credit to forestall the unwelcome return of inflation.

If they can raise rates without causing an unexpected spike, the Fed may end up not jerking the punchbowl away, but slowly draining it. This will be tricky because it not only involves good timing -- acting before inflation becomes a problem, but not moving too soon -- as well as communicating their intentions before acting. Anything less risks an abrupt end to the party.

The Life of the Party

More importantly, fiscal policy has been a key to 2003's economic recovery. President Bush's tax cut gave the consumer the ability to continue spending throughout the recession, even when corporate spending dried up. Not only did this mute the effects of the downturn, it was at least partially a catalyst for the subsequent recovery. The final effects will be felt in the first part of 2004 when taxpayers are refunded the cut from the first five months of 2003.

Where the Congress and President have failed however, is on the other side of the ledger: government spending. The president correctly saw that the best way to spur the economy into recovery is to put capital in the hands of those who can create jobs. But in doing this, he failed to rein in the government spending previously funded by the rebated tax revenue. In essence, the same dollars were expected to go back into the private sector for capital formation and to continue funding government programs.

U.S. BUDGET SURPLUS/DEFICIT

Source: Baseline Over the past 20 years, the U.S. has run a budget deficit more often than not. From 1998 - 2001, it showed a surplus, only to fall back into deficit as a result of President Bush's tax cut and increased military spending to combat terrorism.

The result was a jump in the U.S. budget deficit. That's a red flag for bonds since the government must borrow to finance the deficit, using up available capital and sending rates higher. This, in turn,  squeezes profit margins and slows economic growth. It also contributes to the weakening dollar and the associated problems discussed above.

Late in 2003, the Republicans added to the deficit by sponsoring a $400 billion Medicare bill. Expect more spending plans to be unveiled as the 2004 campaign unfolds. After all, spending brings the programs the electorate wants while fiscal responsibility isn't nearly as sexy.

Stocks usually do well in the first part of a presidential election year precisely because the incumbent does everything possible to shore up the economy to insure his reelection. The second half is a different story as investors start to realize their ramifications.

This year there'll also be some talk of rolling back last year's tax cuts. While this may play well on the campaign trail, it really isn't much more than the democrats' old class warfare argument. This may sway a few votes, but in an election year, there isn't much chance of a tax increase under any guise.

Politics aside, President Bush's reelection would be the best thing for the economy. At this point he's a known commodity and he's already enacted the centerpiece of his fiscal policy. It may sound cynical, but he's less likely to harm the economy than a fired-up democrat.

When all's said and done, the budget deficit is not really the major problem many believe. Unlike your mortgage, it's not a note that has a specific maturity. As the nearby chart clearly illustrates, the U.S. carried a deficit for most of the last twenty years, yet that didn't prevent stocks from staging one of their most powerful rallies, lasting almost ten years.

Contrary to popular rhetoric, the government's deficit is not "a burden passed on to your children". Quite the contrary, if the deficit enables the economy to expand, it's improved conditions for all, including your children.

The deficit only becomes a problem when it spirals out of control -- something it's never really done domestically -- or when politicians use it as an excuse to pass damaging legislation. It's the latter we need to fear, and it's a major threat to the economic party.

Breaking Up is Hard to Do

Given the potential for inflation and the negative effects of the weak dollar, the Fed will need to begin tightening, possibly as early as the second quarter of this year. When that happens, bonds will lose ground. It doesn't have to be a big shock, but it will happen.

As in 2003, we'd expect bonds to return their coupon at best. As long as the economy continues to grow, junk bonds will be the best performing sector given that they trade more like equities than bonds.

Stocks stand to fare better. While higher rates and the weak dollar may squeeze profits, the current bullish mood can easily last into the second quarter if not beyond. Until the yield on the 10-Year Treasury approaches 5%, investors will still be drawn to stocks as the best investment alternative.

But those looking for 25-30% returns like last year are bound to be disappointed. Stocks tend to return around 10% in the second year of a bull market, and that's not counting the headwinds of a presidential campaign.

Besides the weak dollar and rising interest rates, increasingly difficult earnings comparisons and the fact that most companies have already exhausted their cost-cutting efforts will make profit growth more difficult to achieve than last year.

None of these issues is insurmountable, especially if the Fed and Congress are careful in their actions. Missteps could, however, quickly derail the fragile recovery.

The "perfect storm" can't last forever and all parties eventually break up. They just don't have to end badly.

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