“On A Knife’s Edge”
A few weeks ago, I was taken aback by some comments that came from Bill Gross, the well-known manager of a few zillion dollars’ worth of bond portfolios for PIMCO Advisors, based in Newport Beach, California. In recent months, Gross has been as disdainful of the Alan Greenspan-led Federal Reserve of anyone I listen to. The Fed is woefully behind the inflation “curve,” Gross has held, inviting much higher inflation, a weaker dollar over time, crumbling bond prices and all the rest that comes with one of the most expansionary monetary policies in recorded history.
However, in his comments during a CNBC interview, one of the most prominent money managers in the world—and one who has pointed out the above incessantly—for the first time in ages talked about the possibility of a sharp reversal back into deflation at some point. The markets, he pointed out, are “on a knife’s edge.” If recent signs continue that the Fed’s enormous monetary growth are really taking hold, he said, we certainly could get a burst higher in job growth and economic activity; but it would be one accompanied by a more dramatic up tick in inflation than is now anticipated.
The alternative, Gross has now added, is that this monetary stimulus by the central bank has exacerbated the many “imbalances” in the system, all of which are ultimately unsustainable. Housing prices. Consumer credit. The “carry trade” which saw traders for well over a year now borrow money from the Fed at next to nothing, and buy other securities. The result has been inflated prices virtually across the board.
Ironically (as James Grant recently echoed in a New York Times op-ed contribution you can read on the “Other Experts” page of my web site) the Fed’s fostering of inflation has increased the chances that we will at some point slip back into deflation, warns Gross. Market events could cause the dollar to lurch higher, and most asset prices lower; something that could feed on itself, dramatically shrinking their highly leveraged values. The bond guru hastily added that he believes we will get further liquidity-driven “pops” in stocks and commodities—and additional declines in bond prices—before this reversal occurs some time in 2005. However, given that asset prices are already so high courtesy of the Fed’s easy policies, we could just as easily slip off the other side of the proverbial knife at any time.
As I wrote a short time ago, were it not for the remaining artificial leverage in the markets due to the Fed’s nurturing of its many bubbles, our way would be clear right now. Once again, we could be betting on the Fed to butcher the dollar’s foreign exchange value; chiefly, by taking increased positions in commodities, foreign government bonds and the like, much as we did until a few months ago. We may still do this to some extent shortly; I’ll detail the conditions momentarily.
But for now, just one more reminder of how tenuous things are right now. As I wrote in my May 20 e-mail update, another of the best and more recent descriptions of where we’re at right at the moment came from Oppenheimer’s Chief Investment Strategist Michael Metz, in a May 14 CNBC interview. He reminded the audience that there is some $1.1 trillion in hedge funds managed by people with no ideology or preconceived notions, who are merely “directional players.” Those players as you know fed and made even more robust the trends of the last year, by chasing momentum in the dollar (downward) and pushing everything else higher.
Metz fears two things. First, that what unwinding has taken place so far (as measured most obviously the last few months by the dollar’s rally and the decline in metals and bonds) does not remotely account for all of the leveraged positions still in the markets. Second, he wondered aloud whether the gradual unwinding of things such as the bond carry trade in particular will happen in an orderly enough fashion to prevent hedge funds from moving so much/quickly against their existing positions that we have “an accident en route” to what Fed Chairman Greenspan hopes is a soft landing for the MARKETS.
The predicament for the markets and investors, he says, is unprecedented. The huge leverage represented by hedge funds has “really turned the system into one big casino.” It might sound silly given Greenspan’s flooding the world with dollars but, Metz added, a “rush to liquidity” could be triggered were stocks to break down, or bond yields to hit new highs. Hedge funds and others would scramble to cover short positions in the dollar, which would spike higher. This would all feed on itself in Metz’s worst-case scenario, with stocks, bonds and commodities all getting hammered.
Here again, as Gross was wrestling with, the timing is uncertain. If we’re all lucky, the Fed will engineer the markets through Election Day and into next year in tact. One of the prices we’ll certainly pay is additional upward pressure on inflation and interest rates; but this price will be acceptable to the markets, if growth does not appear to be stifled too much. As I wrote last month, Greenspan’s fondest hopes are to nurture a period of inflationary growth that will last (hopefully) until he at last steps down.
THE FED’S NEW ROLE
As it hasn’t had to do in quite some time, the Fed will be hard at work in the coming weeks and months to hold the markets’ hand as it finally begins (at a “measured pace,” mind you) to raise short-term interest rates. Clearly, the markets have been anxious, knowing that this day must finally come; nevertheless, so used have they become to the endless easy money party that they aren’t quite sure what to make of things. This is one of the reasons, as we’ve seen, why the stock market has been unable to mount a sustained rally in spite of what on the surface has often appeared to be great economic news.
In giving us the first of its coming interest rate increases when it meets the end of this month, the Fed will have a few objectives. First, it will explain its likely modest initial rate hike of 25 basis points (a quarter of a per cent) by cheering the economy’s improving fortunes, and its view that modest rate hikes won’t harm them. Second, it will likely convey its continued attitude of not being in a hurry, so as to keep the dollar (which, as I point out on the front page, recently broke its recent up trend) from moving too quickly one way or another.
Most of all, though, it will be keeping a close eye on the bond market. A little relief has come recently, as the yield on the 10-year Treasury note has fluttered back down some from recent highs around 4.9%. The Fed will need to sell the bond market on the notion that it has a realistic grip on things, and will eventually be a bit more forceful than it has been suggesting were the inflation numbers of the last few months to last considerably longer. If it is not successful in doing so, the bond market vigilantes may end up “dragging” the Fed into faster and larger hikes, as they did during a similar time in 1994.
OIL PRICES WILL BE KEY
For all the talk about how wonderfully most of the world’s economies are doing, you wouldn’t know it from the recent panic over oil price levels. Adjusted for inflation, the price of oil is only two-thirds of what it was at its peak a generation ago, even if in nominal terms it recently hit a new all-time high around $43 per barrel.
Nevertheless, consumers can’t pay interest on all the money they have borrowed recently, keep buying more junk they don’t need, AND fill their gas tanks (and heat or cool their home) all at the same time. Clearly, the Bush Administration’s pressure on its ally Saudi Arabia has had some effect; and, led by the Saudis, OPEC now has oil production in overdrive.
In recent days the oil price has started to back off more energetically, especially as news just came out that May’s oil production averaged 28 million barrels per day; this figure blew away the cartel’s new quota of 25.5 million barrels (up from the old one of 23.5 million) slated to start in July. Seeing that OPEC just might be able to bump up production this significantly after all, traders who had piled into oil futures contracts scurried for the exits; and as of this writing, oil prices have already shed nearly $5 per barrel.
Countries like Saudi Arabia and the United Arab Emirates who are doing most of the heavy lifting for Bush-Cheney 2004 are running a significant risk in having done such an about-face. They had better hope that the strong growth in demand from countries like China and India continues, so that prices don’t collapse a few months hence. That is now possible. As we work toward the end of the summer driving season here in the U.S., some of the demand pressure will abate. If at the same time the economy is slowing from its recent pace for one reason or another, prices by late Summer could fall precipitously.
Barring a major monkey wrench being thrown at the world economy, the long-term picture for oil is incredibly bullish (that is, if you own it) for reasons I’ve covered previously. But even Jimmy Rogers, one of the best-known longer term bulls on energy, is also warning that even this market has been wound rather tightly of late; and that before we see $50 per barrel oil a year or two from now, we might first see $30, or even less.
Though this wouldn’t do investors in most energy stocks a whole lot of good, such an easing of oil prices would be like manna from Heaven for Greenspan. Almost instantly, the inflationary pressures from this source would be lessened, giving him the excuse to stick with his measured pace. The markets would cheer; especially the stock market.
A SUMMER RALLY AHEAD?
In stark contrast with their inexorable rise during 2003, stocks have managed only to mark time in this year’s first five months. Wall Street’s “perma bulls” are incredulous. Sure, oil prices are high; but that’s due to strong economic growth and, to an extent, overzealous hedge funds. Sure, Iraq is a quagmire; but come June 30, all will be well there once more. Sure, we’ve been warned anew that terrorists are set to strike in a big way some time in the near future.
But why, they complain, should we all put our lives—and stock buying—on hold when the economic news is so good? For the third month in a row, we’ve had great news on the employment front. Corporate earnings have grown smartly. The Fed is not about to slam on the brakes; in the end, they may stop merely at taking their foot part way off the accelerator.
The market knows all this. The problem is, investors also have some misgivings. Some of the good economic news headlines are undermined by weak consumer sentiment; perhaps Main Street’s reality is different from that featured each night on “Kudlow and Cramer.” Maybe Iraq won’t live happily ever after post-June 30, with Shiite, Shia and Kurd alike opening each day’s session of government in their new democracy by joining hands and singing Kumbaya. Maybe the Fed will still find a way to screw things up on June 30.
Investors’ sentiments of late have been evidenced by the general lack of enthusiasm for stocks. Mutual funds have suffered net outflows for several weeks running now, with bond funds even losing out as investors flock to money market funds. Daily volume has been lethargic. On most days when the market has opened with a strong rally, it has been unable to sustain it.
This somewhat dour attitude, though, is being pointed to as the very foundation for what could turn out to be a summer rally. After all, as the old saw holds, markets often climb a wall of worry; and there are clearly worries aplenty. If oil prices continue to moderate and we don’t get thrown any curve balls by Osama bin Laden, though, sentiment could soon change; and further, any rally that might develop in the near term could really get legs if we get to the other side of June 30 in one piece.
As I have said for a while now (and it’s been pretty good advice these last few months) it’s best to do nothing when the markets are as uncertain as they have been. One of the things that will tip me toward a more bullish attitude, however (if only temporarily) will be the technical behavior of the market. For several months now—as you see here in a chart of the Dow Jones Industrial Average—stocks have been locked in what is described as a descending channel. In the case of the S&P 500, that index’s channel has been less onerous; in the case of the Nasdaq, it looks somewhat worse than the Dow. But the pattern is the same.
How quickly we might get an upside breakout is hard to say; but a preponderance of good news together with further easing of the “issues” (oil, Iraq and the Fed) investors have been fretting over could bring one about. If that occurs, it will need to 1) last more than just a day or two, and 2) be accompanied by a meaningful pickup in both volume and market breadth. And if it occurs, we’ll want to take advantage of it; presently, I expect it would be easiest and most prudent to do so predominantly by buying into a few of the exchange-traded funds (ETF’s) I think would provide the best leverage to a rally.
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