Insights & Advice

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Between a Rock and a Hard Place

Pity poor Ben Bernanke and his men of the Federal Reserve! Caught between rising inflation and a declining dollar on one hand and an economy teetering on the edge of slow to no growth he has few options. This week he tried one time-honored approach—jawboning.

Words are cheap but they carry a lot of weight when spoken by the most powerful central banker in the world. More than once he reiterated that the Fed’s priorities have changed. Inflation, he clearly stated, has become public enemy number one. As expected, his mere threat to combat inflation immediately started things rolling in the way he wanted. The dollar had one of his strongest weeks in months, gold retreated back to the $850/oz. level and interest rates began to climb. Even the oil price hesitated in its rise to the moon.

May’s Consumer Price Index gained 0.6% versus 0.2% last month and was the largest rise in six months. It simply underscored the inflation threat that is obvious to you and I but until now had seemingly escaped the government’s notice. Yet, because the number was not as bad as many feared, the market moved up on the news (go figure). At the same time retail sales for last month rose an unexpected 1% which kind of contradicts economist’s forecasts of a slowing economy. Of course, the government’s stimulus checks began arriving at the same time so May could have been a one-off event in a declining retail sector. Given the unknowns, the stock markets performed in schizophrenic fashion closing down on the week.

In the meantime, the bond market had a similar game going. Traders who usually make bets on future Fed fund rate moves have priced in a 67% chance that the Fed will raise rates ¼ point in August and a 97% chance they will raise rates no later than September. If the Federal Reserve does raise interest rates the hoped- for impact would be to cap commodity prices and at the same time boost the dollar. That would be a good thing. However, raising rates would not be good for a number of sectors of the economy with housing and consumer lending two of the more obvious victims. There is also a chance that rising rates would tip the economy backward and take a lot of shaky lenders and borrowers along with it. Given that U.S. foreclosures jumped 48% in May from a year ago (one in every 483 households), that is a real threat.

So in the short term, Federal Reserve Chairman Bernanke and his Board Governors are out on the stump trying to talk up the dollar. Whispers of possible coordinated Central Bank intervention to bolster the greenback are rampant and the magic is working so far. Of course, as with all verbal communications, at some point words must be backed by action. But right now, it provides a tiny bit of space between a rock and a hard place.

As for the markets, energy continues to call the shots: oil up, market down and vice versa. The S&P 500 is in no man’s land but the technical picture is not good. The S&P finished flat for the week at 1360 while the NASDAQ (2454) was down and the Dow (12,307) up slightly. Volatility has moved up again. Although the S&P index has some support at 1325 a failure to hold there would indicate further downside to th1250 area or so, and that my dear reader would be a decline of 6-7%. So don’t be a hero because it’s no time to be aggressive.

Posted in A Few Dollars More, At the Market