U.S. markets go into the Fourth of July weekend satisfied with what the
served up Thursday. But the Fed's credibility is no more solid, nor is its message any clearer than it has been all year. And inflation is still the
ugly elephant in the room.
As the first half of 2006 draws to a close, the market is reveling in an FOMC-fueled relief rally in stocks and bonds based on the "dovish" statement released Thursday. But the dovish statement follows intensely hawkish Fedspeak throughout most of late May and June. That rhetoric, in turn, was designed to undo the Fed's perceived dovish tone in April.
It seems the Fed, in its effort to be transparent, is chasing its tail, and the markets are caught in the middle.
After nearing its all-time high on May 10, when it peaked at 11,642.65, the
Dow Jones Industrial Average
fell to the year's lows of 10,717.5 one month later on June 13. Other major averages suffered similar fates. The
started the year at 1248.29, peaked at 1325.14 on May 9, and sunk to as low as 1223.69 on June 13. The
started the year at 2205.32, peaked at 2344.99 on May 8 and plunged to 2072.47 on June 13. The Russell 2000 is up 7.6% on the year, but it is down 7.3% from its high in May.
The Dow ended Friday down 0.33%, despite a huge move in
after famed investor Kirk Kerkorian sent a letter to the company recommending a global partnership with Nissan and Renault. But the Dow ended up 1.4% on the week, 0.4% in the second quarter and up 4% on the year.
The S&P 500 dropped 0.2% on the day, but was up 2% for the week, down 1.9% for the quarter and up 1.8% for the year. The Nasdaq fell 0.11% Friday, is up 2.4% for week, but down 7.1% for the quarter and 3.8% for the year, weighed down -- in part -- by ongoing revelations of improper options practices at many of its tech components, including this week at
Applied Micro Circuits
Thumbs Down on the Fed
Options backdating and other developments have influenced trading, but the markets have mainly been thrashed about this year by the Fed's
"This is the law of unintended consequences," says Bill Hornbarger, chief fixed-income strategist at AG Edwards in St. Louis, about Bernanke's market-moving rhetoric. "If you don't know what you want to do, it is hard to communicate in a way that inspires confidence."
With Thursday's dovish statement, the Fed may have actually lost the grip on its handshake with the markets. In the meantime, inflation hasn't shown signs of slowing, and the economy is stronger than most had predicted as the second quarter comes to an end.
The Fed seemed to finally get inflation expectations under control when Bernanke came out with tough talk on inflation at the start of June. The inflation-sensitive markets responded positively: spreads on Treasury Inflation-Protected Securities (TIPS) narrowed, as the price of gold dropped and the dollar strengthened. When the dovish statement came out Thursday, the liquidity-sensitive sectors rallied with the most oomph -- energy, materials and commodity-related stocks. Gold rallied sharply Friday, jumping 4.7% to $616.70 per ounce, while TIPS spreads widened and the dollar fell. These moves point to higher inflation, notes Michael Darda, chief economist at MKM Partners.
"This means a 'thumbs down' in terms of the Fed," says Darda, who believes the Fed's reliance on a moderating economy to dampen inflation is misguided. "A Fed that has a lack of credibility is a Fed running a less-efficient monetary policy and a Fed that needs higher rates to achieve its objectives, and that means a less efficient U.S. economy," he says.
Many economists predict the Fed will hike the fed funds rate to at least 5.5%, and a handful are forecasting a 6% fed funds rate by the middle of 2007.
"It will take time, further Fed tightening and more restrictive financial conditions to cap cyclical inflation pressures," writes Richard Berner, economist at Morgan Stanley. "Many market participants believe that the biggest risk is that the Fed tightens too far ... our scenario may be the bigger risk: The Fed tightens more gradually, and subsequently goes on hold for a 'considerable period' waiting for inflation to come down."
The Treasuries market is also finishing the first half of the year at the start of a rally. Treasury bonds sold off through the first half of the year, as yields on the 10-year Treasury bond climbed to their peak for the year at 5.25% on June 28 from 4.39% at the end of December. The 10-year Treasury bond finished this week at 5.14%, while the two-year ended up yielding 5.15%. At the end of last year, the two-year yielded 4.40%, and the yield curve was similarly flat.
The Fed's efforts have had some impact on reducing the appetite for risk. Emerging markets measured by the iShares Morgan Stanley Emerging Market Index are up by 5.6% for the year, but it is down by 15.5% from its peak. Gold is up 19.5% on the year, but down 15% from its peak of $725 per ounce. Oil has been steadier relative to other markets. It finished Friday up 0.9% at $74 per barrel and is up 21% from the start of the year.
The Fed is undoubtedly aware of the monetary policy at the central banks of Japan and Europe, which are also in a tightening mood. The Bank of Japan is expected to move from a zero interest rate policy sometime this year. Another wildcard for the U.S. markets in the second half is China, which has made strides to contain its easy credit standards and effectively tighten its monetary policy.
Former Goldman Sachs chairman Henry Paulson is widely expected to be confirmed by Congress as the new U.S. Treasury Secretary, after being confirmed by the Senate Finance Committee this week. Paulson is expected to increase pressure on China to let the yuan appreciate and help correct global imbalances. In a potentially contradictory development, Paulson is also expected to be more dedicated to a stronger dollar than his predecessor John Snow.
The stakes are higher as Ben Bernanke enters the next phase of his inaugural year as Fed Chairman, particularly now that the markets are back to expecting the economy to slow, inflation to be "contained" and the Fed to pause. Comments from corporate America's leaders over the course of earnings season on inflation and energy price pressures could once again reveal the elephant in the room.
This weekend's fireworks are likely not the last for the markets.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
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