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Dan Norcini's latest

A Possible Scene from the Playbook of the Fed



I am of the opinion that the Fed, contrary to their recent assertions, would prefer not to raise interest rates in spite of all the malarkey they have been slinging of late in which they are mentioning the"I" word (Inflation.)

They fully realize that the excesses they have created in the system by their loose money policy could very well implode on them if the bond market sell-off turns into a rout. The mere mention of inflation roused the bond vigilantes from their hibernation of the last few years and when they awoke, they were in one snarly mood.

Let's suppose that the Fed were to raise rates in June as many are anticipating they will. Consider the following - automobile manufacturers that have been selling new cars with ZERO down for so long now that the consuming public is going to balk at the idea of actually having to pay for the use of borrowed money. That is certainly not a recipe for jumpstarting new auto sales. Furniture stores have literally been giving away the store with their"No money down; No interest payments until next year" sales or their zero percent financing as well. What do you think bargain conscious consumers are going to think when they are now forced to actually shell out money for interest payments on top of rising prices for finished goods?

Rising rates are going to be one more burden dumped upon an economy that is struggling under rising fuel and food costs that are seriously cutting into disposable income. Home mortgage refinancings are already slowing down and with that slowdown comes a decrease in the cash cow that homeowners had been milking for the wherewithal to continue their uninterrupted consuming binge.

Nothing good can come out of a series of interest rate hikes especially if it appears the Fed is moving from a loose money policy to a longer term tightening policy. The additional strain of the rising cost of debt service would work to put the brakes on any so-called"recovery" and therefore work crosswise to the Fed's purpose.

Additionally, they must keep consumer confidence high enough to induce John Doe to continue opening his check book and bury himself deeper into debt instead of retrenching and actually paying it down and increasing savings. What's the Fed to do? One thing is for certain - the Fed cannot afford to see the stock market rollover and for the next leg in the bear to reassert itself. Why? Ask any average American how the economy is doing and they will look at one number to give you an answer - the level of the DOW. As long as the DOW is rising, it's"let the good times roll." Let the DOW slump and commence a brutal leg downward and the fickle public will begin fidgeting and shut those same checkbooks tighter than Dick's hatband. The entire mood of the country will sour faster than milk left outside on a summer day. Since consumer spending is the biggest part of the economy, any slowdown at that level would be disastrous for the nascent recovery that the Fed has worked so hard to engineer.

The problem that the Fed is faced with however is those infernal bond vigilantes who have mauled the bond market out of inflation fears. Bond players are telling the Fed to hike and signaling to stock investors that inflation fears are rising. If bonds continue to break down and push interest rates higher, the Fed is in deep trouble and they know it. So they have two areas that they must focus on in their intervention gambit. One - the Dow; Two - the bonds.

They must continue their intervention via the repo pool periodically propping up the DOW miraculously resuscitating it from the depths whenever it appears it is on the verge of completely rolling over. Additionally, they must somehow manage to keep the bonds from further breaking down with the resulting rise in rates on the long end while simultaneously signaling to the bond market that they will take necessary steps to combat any nascent inflationary pressures. If bond pitsters get the idea that inflation is spiraling out of control, they will crush the market in resounding fashion. If the DOW gets out of control on the downside and/or interest rates begin to escalate in earnest, consumer confidence will effectively get mangled.

We have seen what happens to the stock market at the mere thought of rates rising a measly 25 basis points. Imagine the reaction of the stock market to a 50 point hike or even a 75 basis point hike if the Fed were to telegraph that as certain. How long do you think the DOW would hold at current levels? Not long is an understatement. Yet, if the Fed backs off its inflation talk and gives the appearance that they are ignoring the ramifications of the rampant liquidity they have pumped into the system, the bonds will punish them.

What is the current solution to their dilemma? Talk up the inflation fear thing and give the market the impression that they are on the ball and are proactive and not reactive. That way they hope to stabilize the bonds from dropping any further. If they do take the risk of hiking, hike the bare minimum and give the impression that they will not keep a heavy hand on the spigot. But even that talk makes stock investors nervous as rising interest rates will raise corporate borrowing costs when pricing power has still not returned and serve to crimp consumer spending as already outlined above. Stock traders will respond by dumping stocks derailing the DOW and spooking the public; the very thing the Fed is trying to avoid.

Here’s where things might get interesting. If you recall, last year we experienced a time in which money flows went into and out of bonds and out of and into stocks depending on the direction of the stock market as a whole. Strong upmoves in stocks saw money move out of bonds. Down days in the market saw money move back into bonds. Investors were not quite sure whether the recovery was for real and thus were very nervous for signs of weakness in the economy. The first whiff of weakness, they sought out the ‘safety" of bonds and the safe-haven play was on. That served to keep rates low on the long end; precisely the thing the Fed was happy to accommodate since mortgage rates would stay at 45 year old levels and credit would remain loose. If we got a day in which things were looking up for the U.S. economy, money would flow out of bonds and back into stocks as confidence grew that it was just a matter of time before happy days were here again. This ping-pong game went back and forth for some time until the br
oad market finally broke the downtrend and began to move up.

I believe the Fed may very well attempt to pull a rabbit out of its hat and try to recreate a similar scenario this year. The manner in which they might very well go about doing this is to let the DOW fall by removing the floor of support underneath it that they have created with the repo pool. As a side note - My friend Mike Bolser is the authoritative source on the use of this pool to manage the DOW and I would refer the reader to his site, http://www.pbase.com/gmbolser/interventional_analysis, and to his daily commentary in Bill Murphy’s daily Midas column at the Café. If the Fed can engineer enough of a drop in the DOW, we could very well see a flight out of stocks into the relative safety of bonds once again. This would suit the Fed’s purpose quite marvelously. It would free them from the onerous burden of monetizing across the yield curve and would offset the work of the bond vigilantes. If enough of this safe-haven flow could be induced, it would serve to push interest rates on the long end back do
wn as the bond market would no longer be a one way bet and a significant amount of short covering could be temporarily generated.

The key would be to induce enough of a sell off in the DOW to create this flow without creating a full fledged panic. That is where the repo pool would come in. The Fed could apply the right amount of pressure (or better stated - get out of the way and allow gravity to work) to bring the DOW down slow enough to avoid a rout but enough to generate some fear among stock investors - one thing which we have not yet seen. The knee jerk move into bonds would then take place. They would do this by managing the repo pool stepping in if they felt things were getting out of hand and moving the DOW back up. This could take place over the course of the next two or three months and would serve to keep the liquidity spigot open and the credit creation machine running in top form. Bonds would get a bid underneath them and stay that way.

Then as we approach September, the Fed could turn its attention back to the stock market. October tends to typically be a bad month for the markets and thus the timing of the Fed would be perfect. Besides, the current Administration does not need a falling stock market in the 2 month period prior to the election. After all, it would be quite a feat to run about the country extolling the economic recovery if the DOW is sinking like a lead balloon. The Fed would begin to act in earnest and ramp up their repo issues providing them with plenty of fodder for ginning the markets northward conjuring up a nice solid uptrend in the DOW. Money would flow out of bonds back into stocks bringing with them the consequent rise in long term rates but from already reduced levels. If they play their cards correctly, they might even manage to have long term rates at the exact same level as they are currently sitting. That would indeed be a master stroke of genius.

Of course, we know that this entire game is destined to fail in the long term but I believe that the Fed is really not in the long term thinking business these days anyway. They live for the short term and plan for the short term. How else could you explain the bubbles that they have presided over for the past 6 years or so?

Perhaps this entire scenario I have sketched out is completely implausible and has as much chance of taking place as snow in July. If so - I can live with that as this certainly is not intended as a definitive statement or some sort of oracular pronunciation. On the other hand, I never thought I would live to see the day that the stock market, the bond market, the gold market and the currency markets are regularly manipulated and managed by the financial elites in this nation either. Given that this sort of thing has become so commonplace and obvious that all but the willfully blind can see it, I put nothing past the these boy wonders who are nothing if legends in their own minds. I do not know about you, but I get the distinct impression at times that we in the public are viewed by our financial lords and masters as some sort of Nintendo characters who can be controlled by moving a few knobs and buttons on a game controller and I for one am getting tired of it.

Dan Norcini

May 20, 2004

Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at dnorcini@earthlink.net with comments.