June 2008

This analysis should not come as a surprise, considering both the Federal Reserve and the U.S. Treasury have already done a great deal of the “heavy lifting”.  

In a highly anticipated move, the Federal Open Market Committee met and lowered the funds rate by 25 basis points at the meeting on April 30. In the post-meeting statement, it was thought the Federal Reserve was trying to signal that the rate reductions were nearing an end. At least that was the impression that was taken away by both Wall Street and Main Street. The futures market began to quickly predict an almost 100 percent probability of no further rate decreases, certainly none at the next meeting to be held in June.

How did the other markets react? The U.S Treasury market saw prices sell off, while rates began to rise. The two-year treasury-note, at one time was over 2.50 percent. Imagine a two year investment above 2.50 percent. I, like many of you, find it hard to believe that we are getting excited about a meager 2.50 percent investment. But after having tested 1.50 percent, this rate doesn’t look so bad. The stock market, as measured by the DOW, also improved. If interest rates are going to remain at 2.00 percent, why is the stock market rallying? My best guess is because if the economy is perceived to be improving well enough for the Federal Reserve to stop lowering the overnight rate, then it is also a sign that the economy will begin to improve and the stock market will also benefit.

Do not lose sight of the large amount of money on the sidelines. This is money in stock and bond funds. Managers of these funds do not want to miss the “bottom” or what they perceive to be a cheap entry back into stocks.

To complicate matters, an old nemesis is beginning to raise its head. A few members of the Federal Reserve, as well as some economists on Wall Street, are beginning to express concern about rising inflation. The President of the Cleveland Federal Reserve, Sandra Pianalto said in a recent speech, “Consumer prices are rising faster than I’d like and inflation is a ‘key risk’ to the economic outlook.” Presidents Fisher and Plosser, as well as others, have expressed similar concerns.

These officials are not alone as a recent Reuters/University of Michigan Survey of households showed inflation expectations rising to 5.2 percent over the next 12 months. That would be the biggest jump since 1982. In the same survey, the five-year expectations rose to 3.3 percent, the highest increase since 1996. These perceptions of future inflation are quite disturbing. It is not always reality, but sometimes the perception of reality that causes fear and can become self-fulfilling.

So are we past the halfway point? I would have to agree we are. But what does the other half hold in store? That is another question, and perhaps a subject for a future issue of FYI!