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August 7, 2006
And then the markets realized that a pause may not be great news after all...
The stock market likes low interest rates because they stimulate investment and because a lower interest rate means less discounting of future profits. Of course, a slowing economy is not good for investment or profits. Hence, all the jubilation over the possibility of a pause in the rate hikes might be a little premature. (CNN Money)
Yippee! Stocks rallied; bonds surged; bets for a rate hike Tuesday dwindled down to 16 percent from 41 percent the previous day, according to Chicago futures trading.
And within an hour the rally was gone.
"The market seemed to realize almost immediately that the Fed pausing now because it is worried about economic growth is not a good thing for stocks," said Ken Tower, chief market strategist at CyberTrader. "Weaker economic growth means weaker profits."
...
[MKM Chief Economist Michael] Darda said that he thinks the economy will show greater strength in the fall, which could lead to a need for more rate hikes. Additionally, all the analysts said that they were worried that rising inflation would force more rate hikes going forward, a scenario even more troubling for stocks.
Not sure about Darda's comment. I'd expect somewhere in the 2.5% to 3% range for GDP growth, which is not necessarily enough to trigger more increases. It is, of course, the inflation part that worries me. If they let real rates fall and expected inflation rise as a result of pausing too soon, then you could have a much more difficult situation to deal with.
So... bottom line: what will they do? The IEM is putting it at about 70-30 for a pause. That's up from 60-40 on Friday. It will probably inch higher by tomorrow. At this point I'd regard a pause as at least that likely. I still think there is a possibility of an increase but the more the market's expectations get entrenched, the further the Fed would have to go out on a limb to go against them. So it's not a sure thing, but it's tough to bring yourself to bet against it. I would prefer one more increase, but you knew that already.
Will there be dissent? Who knows. That's not something I'm going to try to predict. Remember that in Fed culture dissenting sends a strong message. Generally no more than one person dissents even if there is significant opposition. Early in the term of a new chair, I would expect that members would want to maintain a unified front. The bar for dissenting might subjectively be set a little higher, even for hawkish members. If the vote is unanimous, I would not interpret that as meaning that there is no sentiment that rates need to go higher. We will need to see the minutes in 3 weeks to know more. I know that some of my more hawkish readers may want or expect someone to dissent. There may be, but I'm just saying not to expect it or read too much into the lack of it. A unanimous decision now does not preclude rate hikes in September or October, if necessary.
UPDATE: Barry Ritholtz puts a higher probability on an increase than I do.
I think the odds of a 1/4 point hike is much higher than people think; I place it at 49%, versus the 18% or so the Fed Fund Futures have on it
I'd split the difference at around 30%, maybe a little less.
Meanwhile, King Banaian returns to SCSU Scholars and would bet on an increase.
I know what the numbers say. I also think I have a handle on Bernanke; he is sufficiently stung by previous perceptions of being an inflation dove that he probably needs one good 'sting' of the markets to get them to pay attention to what he says rather than what they think he's going to do. I won't be surprised if the string of increases ends tomorrow, but I'm betting on the momentum instead.
...
This is a cautious bet, so I'm only putting down $10 -- i.e., half the beer money -- on a rise tomorrow. But still, at about 4-1 odds it's a nice opportunity. Besides which, if the Fed starts saying the economy has slowed... If I'm right, want to bet on the market's reaction? I say 'up'.
Sounds like King and I are on the same page. No one is talking about betting the farm here, but I certainly think the market's 18% probability is underestimating the potential for a surprise. How will the market react? Well, given how often I talk about the stock and bond markets overreacting to Fed statements, I'm not even going to guess. The market may need some time to digest it before it figures out where it is going.
Posted by William Polley at August 7, 2006 2:55 PM
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Comments
Here is an interesting way of looking at consumer prices and inflation: Consumer Prices are actually down 50% over the past 5 years, if you were saving and using gold as your currency, rather than dollars. Full analysis at:
http://goldstockpicks.blogspot.com/2006/08/consumer-prices-down-50-over-past-5.html
Consumer Prices Down 50%
Posted by: goldguru at August 8, 2006 7:58 AM