What the Fed Really Said

For those interested in the vagaries of the market and the influence that the Federal Reserve has on the economy and the markets, John Mauldin has some analysis and prognostications:

Thursday saw a powerful response by the markets in stocks, bonds, commodities, and currencies to the communiqué from the Fed after its recent two-day meetings. Clearly, some were interpreting the communiqué to mean that the Fed had finally come to an end of its interest-rate-hiking ways. The immediate spin was quite "dovish" in terms of future rate hikes and concern about inflation.

That has become a pattern in the last year. The Fed releases its minutes, the immediate spin is that we are ready for a "pause," and the market rallies. Then we start to listen to the speeches from Bernanke and various Fed governors and are shocked - shocked, I tell you - that nothing has really changed and they intend to keep on raising rates in a measured manner.

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Now, one can read the statement to make a case for a pause in September. There will be two more inflation numbers before the September meeting. If the economy is slowing down and inflation is coming down, both of which are possible, then the Fed may indeed pause. But let's think about that.

A slowing economy is not going to be good for profits, and thus not good for the stock market. But if the economy continues to rip and roar along with inflation at an elevated level, then the Fed is going to continue to raise rates. There are now some maverick calls that the Fed rate will be at 6% by the end of the year. If you are bullish on the economy, then that is a perfectly rational expectation.

But if rates continue to increase, then that is ultimately not going to be good for mortgage rates and the housing market. That will also impact consumer spending. That outcome is not good for the stock market either.

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I think it is highly likely the Fed will keep raising rates until we get either a slowdown or a recession. The irony is that the quicker the slowdown comes into view, the less severe it is likely to be. Why?

If the economy starts to weaken in the third quarter, with inflation coming back down, the Fed will stop raising rates. Given where we are today, it is likely we get a simple mid-cycle slowdown, just like we did in the mid-'80s and mid-'90s, and then the growth cycle continues.

But if the economy stays strong and inflation pressures do not abate, the Fed will raise rates higher and higher, which will ultimately put more pressure on the housing market and consumer spending. The risk is they go a raise (or three) too far and the economy falls rather swiftly into a real slowdown and/or a recession.

So, later in the summer, we are likely to be in the perverse situation where good news is bad for the markets and bad news is merely less bad.

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There are any number of headwinds to the economy, as Shilling and others (including your humble analyst) have noted. Among these:

1. High energy prices serve as a tax
2. Central banks everywhere tightening
3. A slowing housing market
Sooner or later, I think they will take their toll. The growth in consumer spending in recent years has been driven by rising home prices and the ability of US consumers to have access to cash-out financing. Higher mortgage rates are going to limit the growth in home prices and the ability of consumers to borrow, as well as drain more cash from disposable income. With wages barely rising in line with inflation, and not keeping up with the inflation of daily living, I think the potential for a consumer-led slowdown or recession is significant if the Fed keeps raising rates beyond August, and maybe/probably even if they do pause in September. That will not be good for the markets.

As my friend Matt Blackman noted recently, the trend is for the market to bottom in the third year of the presidential cycle. That would all fit if there is a recession and the inevitable recovery in 2007. I continue to suggest that readers look at absolute-return types of investments and be very careful of long-only stock market investments. The time will come when it will be safe to get back in the water. But in my opinion, that is not today.

Note: From Frontline Weekly Newsletter by John Mauldin. (John@FrontLineThoughts.com)