Has The Fed Gone Too Far?

Good day. Well, I hope you had a nice weekend. In another case of the markets believing that “Deficits Don’t Matter,” the dollar rallied on Friday after yet another record trade deficit was posted. I just completely fail to see how this can continue to happen. Sooner or later, you have to pay back the debt, or pay the piper, if you will. And since our manufacturing has gone to you know where in a hand basket, there are only two things left to correct this mess. I’ve gone over them time and time again, but here goes again.

One involves a deep dark recession, and the other involves a huge correction in the dollar downward. Many economists say this debt situation is unsustainable over the long run, arguing that the United States could eventually face a harsh correction that would depress spending, increase the cost of borrowing and sharply lower the value of the dollar.

“There are certainly going to be inflows, the question is at what price?” said James O’Sullivan, an economist at UBS, an investment house. “As time goes on, it will become a little more difficult to attract foreign funds. That’s another way of saying the dollar will fall.”

OK, enough of that. The trade deficit came in at $65.7 billion for December, putting the total annual trade deficit around $725 billion. That put the total up 17.5% from 2004, marking the fourth straight record.

Yes, there are those that claim this shows economic strength, and I’ll give you that to a degree, but there are still questions of exports and overspending by consumers.

So, as I said in the opening lines, the dollar has rallied. And this time, the rally has taken the euro back below the 1.19 handle. This is the strongest level the dollar has seen in 2005 and it’s not just the euro that is being taken to the woodshed by the dollar. Line the other currencies up, and there will only be a few that get to step out of line.

The Chinese renminbi is one of the few that gets to step out of line, as it hit yet another post-dollar-peg high of 8.0458. This currency continues to work at a pace that will have it trading 7.50 to the dollar by year’s end.

Tomorrow, we’ll see the color of January’s retail sales, which judging by the activity in the Butler household index should be somewhat strong. It won’t be soaring, just somewhat strong. Later this week, we’ll see the latest net foreign security purchases data for December. This data has been so wild and wooly in recent months, and this month shouldn’t change any of that. Right now, the United States is barely seeing enough purchases to finance the current account deficit, and direct investments.

It certainly looks as if the markets want to do a Sly Stone and take the dollar even higher. I have no idea why, but they do. Yes, interest rates here are going higher, even though it looks as though interest rates have already gone past neutral. Here’s a snippet from my friend, John Mauldin’s weekly e-mail, which can be found at: http://www.2000wave.com

“My guess, and it is only that, is that he and other Fed members are making a case for at least one and possibly two more rate increases. That will take the Fed funds rate to 4.75% or 5%. But Paul McCulley argues, and I agree, that the Fed funds rate is already past neutral.”

Paul McCulley goes on to say, “In the fullness of time, we believe strongly that today’s Fed funds rate will prove to be not neutral, but restrictive, as evolving weakness in residential property activity self-feeds in reflexive fashion. To be sure, time may not yet be cyclically full. But, ironically, the more the Fed pushes the conventional Taylor Rule envelope, the greater the probability that our secular forecast is right!”

So, there is some thought out there now that the Fed will probably overdo the rate hikes, thus stomping on the economy’s heart, and smashing that sucker flat, The Fed will have just sorta stomped on the economy’s aorta!

The problem remains that you don’t really know that the Fed has gone too far until it is too late. However, in this case, with consumer spending slowing down, the housing sector teetering, and an inverted yield curve. I would stop if I were Big Ben.

Speaking of the yield curve: Yes, it went inverted last week after the auction and return of the 30-year U.S. Treasury. The auction went quite well, and pushed the yield down. The yield curve is now inverted. History tells us that this situation normally spells a pending recession, or at least a real big slowdown in the economy. Recall that a month ago, George Soros predicted that the United States would suffer a recession in 2007? Well, now George has the yield curve to point to and crow.

I read a story yesterday regarding Barclays Capital and Morgan Stanley, two of the biggest dollar bulls in 2005, now expecting the dollar to fall. Now, I have to tell you this: A currency strategist at Morgan Stanley has this to say (tell me if this sounds familiar), “Once the Fed’s tightening cycle is over, dollar bears are going to focus on the Current Account Deficit again.”

Of course it does. Your Pfennig writer has been saying that for some time now!

Gold took another shot to the chin on Friday, which I see as healthy. These hedge funds can really knock the stuffing out of an asset when they put their minds to it. But in the end, I would look for gold to recover, and use this selling to form a nice strong base.

Currencies today: A$ .7380, kiwi .6795, C$ .8650, euro 1.1895, sterling 1.7405, Swiss .7645, ISK 63.95, rand 6.18, krone 6.82, forint 211.41, zloty 3.1885, koruna 23.90, yen 118.10, baht 39.30, sing 1.63, China 8.0458, pesos 10.5180, dollar index 90.69, silver $9.2750, and gold $550.

That’s it for today. That was a big snowstorm in the Northeast this past weekend. I hope everyone is safe and warm! Lots O’ Data this week to sift through, so we’ve got that going for us! One more week before the four sweetest words are spoken: pitchers and catchers report! Tomorrow is Valentine’s Day. I’ve given you plenty of heads up on this, so don’t blame me when you have to visit chateaux bow wow because you didn’t take care of your sweetheart! Have a great Monday and week!

Chuck Butler
February 13, 2006