What the Feds Have Wraught: Global Stagflation Stage 3

Introduction:

My analysis comes from unique perspective in this market and it is only fair to reveal my bias. I firmly believe that it hasn't clouded my ability to judge the situation accurately, but it needs to be disclosed. For about a week after the bailout package was passed, we saw the U.S. Treasuries drop. They were headed very close toward levels that would create at minimum a new mini refinancing boom. As a mortgage professional, this was news that I welcomed. On Tuesday evening, I checked the U.S. Treasuries and they were already trading slightly downward indicating that Wednesday would be another good day. I then woke up on Wednesday to the news that the central banking system would cut their major short term rates significantly. The Federal Reserve cut its Federal Funds Rate to 1.5%. This was coordinated with rate cuts from most of the other central banks. Beyond this, the Federal Reserve has flooded the banking system with new liquidity, and the most recent news has the Treasury buying significant pieces of major U.S. banks. All of this news has been met with mixed reviews by the equity markets, it has however had a unanimous verdict in the Treasury market. That is serious negative. Treasuries have gained more than a half a percent in the last four trading days, and mortgage rates have gone up nearly one percent.

Now then...

Inflation works in unison of a weak currency and higher interest rates. In other words, one drives the other driving the next and the last follows. Anyone of the three can be the driver but almost always the three follow each other. Why is this important? It's because what we have seen over the last few days is skyrocketing interest rates lead by the U.S. Treasuries and a weakening Dollar. No one is worried now about inflation because everyone assumes that our economy is so weak that the only worry is deflation. This may still be the case, however two of the three drivers are already materializing.

As I mentioned earlier, the U.S. Treasuries have gained about a full half point over the last four days. Now, this is of course a short term movement and thus it isn't necessarily a fair indication of anything. Yet, things move as reactions to other things. The central banking system has dropped short term rates furiously and they have flooded the market with new cash. Furthermore, we haven't even yet had to deal with the massive borrowing of the Treasury in order to procure the bailout. These are all inflationary drivers and rising long term interest rates, through U.S. Treasuries, is exactly how the market has read the moves.

What has the Dollar done? The Dollar has also been weakening against most major currencies. Again, we are only looking at a few days of data, however what we have is the natural reaction to the stimulus that the Feds have given the market. In other words, while it may only be a few days, the market is reacting in the very inflationary manner that one would expect when the central banks drop short term rates furiously and flood the market with new money.

What does it mean if this inflationary trend continues more long term? It means that interest rates for thirty year mortgages will soon go into the sevens. Now, think about the consequences of that. Most people agree that our economy won't recover until the housing market stabilizes. Is there anyone that believes the housing market has any chance of survival if mortgage rates are in the sevens? Signficantly higher rates mean that most folks with good credit will have almost no motivation to buy. Why would anyone move from a rate in the 5's or 6's to a rate in the 7's. Now, this maybe a double edged sword, because, if they have less motivation to buy they also have less motivation to sell. That said, what this market really needs is activity, and if rates are in the sevens, then activity is almost impossible.

Second, a weak Dollar means that both oil and commodities will go up. Oil has increased the last couple of days and while commodities have been mixed. Of course, if the Dollar continues to get punished, you WILL see both go up because each is priced in Dollars.

So, what have we set up then with this policy? The aggressive loose monetary policy has guaranteed significant inflationary pressure. This has caused both long term interest rates and the Dollar to go up. With interest rates going up, it has made it nearly impossible for the housing market to stabilize. If the housing market doesn't stabilize we are going to continue in this recession. Meanwhile, the monetary action has increased the likelihood that we will also see inflation on the horizon. As I said, global stagflation stage three.

Now then, let me give an alternative scenario. The Fed would have not panicked. They would have limited their action to the bailout. They would have allowed mortgage rates to continue to drop until a mini refinancing boom would have been created. This mini boom would have created its own liquidity. Would it have been enough on its own? No one will ever know, however the alternative action would at least have guaranteed that we would not be dealing with inflation on the horizon. The current strategy hasn't yet resolved the first problem and it has already created a second one.

Now, is all of this self serving...absolutely. Does it also make sense...that's for the audience to decide.