The Fed Follows Through

Good day… Chuck will be a little late this morning, so he asked me to get the Pfennig out for him today. As usual, he sent me his thoughts on the big news of yesterday – the rate cut and announcement by the Fed. So here are Chuck’s thoughts on the FOMC move:

“Well… The Fed did cut 25 BPS to 2% on Wednesday, just as I thought they would… And they tried a back door curve ball to try and wiggle out of a basses loaded jam. You see, the Fed had loaded the bases with rate cuts, and the markets were at bat, looking for the Fed to pull a Roberto Duran and say ‘no mas’ with the rate cuts…

“The Fed decided to leave out some language that had the markets thinking they had figured out the Fed… But in reality they know nothing more than they did earlier in the day! You see… The Fed removed the ‘downside risks to growth’ clause as well as the statement that, ‘the committee will act in a timely manner as needed to promote economic growth and price stability.’

“OK… On the outside looking in, this looks like a wink and nod from the Fed that they are finished… But… I don’t think they are! And you know what? I don’t think everyone else will buy it either, once it sinks in to some of the hard heads on Wall Street.

“The currency participants didn’t go for the back door curve ball, and they took the hammer away from the dollar… But not a huge swing back in the currencies’ favor… Not yet…

“I explained yesterday that the Fed wouldn’t come out and say ‘no mas’ because they would have egg all over their collective faces when the jobs report for April prints on Friday… And the Fed didn’t… They removed some language, but left Pandora’s Box of interest rate cuts cracked open.

“A couple of months ago, I told you that I believed the Fed would cut rates down to 1.50% before stopping… They are now at 2%… And I’m not backing off that statement!

“Oh, and before I go and hand this back to Chris… (No there’s not a word from our sponsor!) I wanted to touch on the GDP preliminary printing for the first quarter yesterday… It came in at 0.6%… And you should have seen the media jumping all over this saying, “See we averted a recession!”. Yeah, right… Without a good dose of government spending, and a swing in inventories, GDP would have been negative…

“Household spending grew at the slowest pace since our last recession of 2001…

“So, hey! You dollar bulls… Keep propping up those dollars… There’s no risk in the economy or markets these days! NOT! Knuckleheads… The whole lot!”

Thanks to Chuck for making my job a whole lot easier this morning! So with the Fed cut ‘in the bag’, and no clear sign from them if in fact this is the last cut, the dollar held its ground. But overnight, Asia decided the recent dollar rally was a bit overdone, and took the dollar back down, moving the dollar index below 72.50, where it was trading at the beginning of the week. But Europe turned it back around again, and rallied the dollar back to where it was trading right after the FOMC announcement.

As Chuck suggested, the language of the FOMC statement isn’t clear, so everyone is trying to put their own spin on it. There are several stories out this morning that suggest we have avoided recession and are starting to move forward again, while others suggest we have several more quarters of negative growth before we see a turn around. Treasury Secretary Paulson seems to be right in the middle, suggesting that the credit crisis is probably about half over.

“We are closer to the end of this problem than we are to the beginning,” Paulson said in a Bloomberg interview. Even with “headwinds and despite some of the things that we’re going through, this economy is still growing, albeit modestly.” Sounds like Paulson is still pushing the Kool-Aid (and drinking some of it himself). The FOMC will meet next on June 24-25 and current expectations predict they will leave the overnight lending rate at 2% for the rest of the year.

But a pause in interest rate cuts doesn’t necessarily mean the dollar would rally over the next several months. Mike Meyer pointed out a research piece yesterday from Credit Suisse Group that showed the that dollar index fell 8% by the end of the year after the Fed stopped lowering the target lending rate in June 2003. So even if the Fed does decide to pause, which I don’t believe will happen, the dollar may still have some room to fall.

After all, even though the GDP figure was slightly positive, the fundamentals haven’t changed. “Economic activity remains weak,” the FOMC statement said. “Tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.” The gain in GDP reflected an increase in inventories as consumers retrenched and companies cut investment. Spending by households, the biggest part of the economy, grew last quarter at the slowest pace since 2001, amid mounting job losses and surging food and fuel prices. Data that will be released today will probably show further weakness in employment with the weekly jobless claims coming in above 365K.

We will also see the ISM Manufacturing number which will show a further weakening in the manufacturing sector. Finally, we will get the monthly construction spending and total vehicle sales, both of which will show continued weakness. On the drive in this morning, I heard a piece on the number of U.S. consumers who are getting behind on their car loans. Loan delinquencies in the auto sector are at 17-year highs. When you think about it, the two biggest loans U.S. consumers take out are on their home and car. We have all heard about the crisis in the housing market, and it looks like we will have a similar crisis in the automobile sector now. Several customers are ‘upside down’ in their car loans, as they paid too much for huge SUV’s, which are now worth substantially less with gas prices skyrocketing. Just another drag on our already over leveraged consumer, and further proof that we are still nowhere near the bottom of this economic downturn.

The FOMC wasn’t the only central bank meeting yesterday, as the Bank of Japan announced they would leave rates unchanged. This was again largely expected by the markets, but some of the accompanying language showed their concern with inflation. The BOJ predicted that inflation would accelerate but also cut its economic growth forecast. The report tried to downplay any predictions of interest rate moves, and the markets seem to think the BOJ will leave rates unchanged through the end of the year. The yen (JPY) didn’t really react to the news, as markets had already predicted the outcome.

The Japanese yen will continue to be at the mercy of the ‘carry trade’. When the markets are worried about risk, the carry trades will be reversed and the yen will rally, but when risk is no longer a worry, the carry trades will be put on and the yen will fall. Right now, the markets are putting carry trades back on, so the yen has been sold. But I believe there will be another ‘event’ similar to Bear Stearns, which will remind the markets that all is not well and these carry trades will again be reversed and the current 104 levels on the yen will look cheap.

With the Fed failing to raise concern on inflation, gold continued to drop. Investors move to gold as both an inflation hedge and as a safe haven during high-risk periods. Lately, investors have started moving back into riskier assets and away from the relative safety of gold. Again, I don’t share the rosy picture that these investors have, and believe we will soon be reminded of the risk that remains.

Currencies today 5/01/08: A$ .9386, kiwi .7792, C$ .9827, euro 1.5528, sterling 1.9867, Swiss .9558, ISK 75.07, rand 7.5793, krone 5.1122, SEK 6.0179, forint 162.72, zloty 2.22, koruna 16.295, yen 104.11, baht 31.65, sing 1.3582, HKD 7.7930, INR 40.59, China 6.9914, pesos 10.489, BRL 1.6622, dollar index 72.88, Oil $112.92, Silver $16.68, and Gold… $856.20

That’s it for today… We are all hoping and praying that things go well for Chuck this morning! He got to see a great game yesterday, and the weather helped out with temps staying in the ’70s. I can’t believe it is already May, this year is really flying by. Both Chuck and I will be traveling during May with the Las Vegas Money show and a Sovereign Society meeting in Panama. All the travel can be tough, especially on Chuck, but he loves ‘spreading the word’ on EverBank and the benefits of portfolio diversification. Hope everyone has a Terrific Thursday!!

Chris Gaffney
May 1, 2008

The Daily Reckoning