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Is the Free Money Party Over?

-- Posted Monday, 21 December 2009 | | Source:

By Andrew Mickey, Q1 Publishing

Is the Fed’s free money, economic “reflation” party coming to an end?

There are a lot of well-publicized signs it may be.

Inflation is starting to tick up. The Labor Department reported this week its inflation measures rose at annual rates of 1.8% (CPI) and 2.4% (PPI).

On the unemployment front, “good” news is just around the corner too. The Census Bureau has to finish up its search for 1.4 million temporary workers in the next few months. Also unemployment benefits will start expiring soon for many folks. Which means people will leave the work force or take whatever jobs they can get, both of which reduce the official unemployment rate. (Side note: The impact of these two events should be noticeable shortly after Congress’s jobs program is enacted – pure “coincidence,” your editor is sure)

On top of that, the hottest reflation trades are showing their first significant weakness in a long time. For example, real assets like oil and gold are 10% below their recent highs, China stocks have failed to set new highs, bank stocks appear to have hit a wall, etc.

On the surface, it’s not looking good for the fed-fueled, reflation trade. Remember, the market is looking for signs the Fed will keep rates low to fuel the current rally to new highs – bad news is good news.

But if you look past the most closely watched indicators, it’s much easier to see when the Fed will hike rates and put an end to the party. It’s probably farther away than most believe. Here’s why.


Keeping One Step Ahead of the Fed

The entire relation trade has depended on the Fed. The low rates have allowed traders to borrow money for free and buy anything that’s going up. The low rates have also encouraged savers to look for better returns outside the lowly yields of money markets, bonds, and CDs.

That’s why the current rally depends on the Fed keeping rates low all eyes are on the economic indicators the Fed is watching.

Everyone is trying to get a jump on when the Fed will raise rates and dissecting every bit of economic data very closely. But there’s a much easier (and accurate) way to do that.

You just have to look at the current economic situation from the Fed’s perspective.

You know, think like your enemy, to beat your enemy.

Inside the “Person of the Year”

Right now the Fed believes it is fighting another Great Depression. To them that means an all out war against deflation.

Just listen to Bernanke’s past comments on the Great Depression. It doesn’t take long to see he truly believes deflation was the cause of the Great Depression.

This excerpt from Bernanke’s speech at the National Press Club in 2002 explains it all, Deflation Making Sure It Doesn’t Happen Here:

The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

Clearly, they’re at war with deflation. “Whatever means necessary” is a powerful statement.

The thing is though, the big headline makers like unemployment, CPI, and gold prices, don’t matter much to the Fed. There’s something much bigger they’ve got their eyes on.

A Pattern Makes Perfect

That’s why we have to look at what the Fed is watching to see if the economy truly is recovering.

That is credit.

You see, the end of every recession has been marked by a rebound in the rate of consumer credit expansion.

The chart below shows the rate of consumer credit expansion since the 1940s:

It doesn’t take long to spot a pattern.

Each recession coincided with a rapid decline in the rate of consumer credit expansion.

Each recovery coincided with a rapid increase the rate of consumer credit expansion.

There’s no reason to expect the current recession to be any different.

This is what the Fed is watching closely as the true signal the recession is over. And so it is when credit expands, they’ll start to raise rates.

That hasn’t happened yet and it’s not likely to happen anytime soon.

The Forest and the Trees

Once again, there’s going to be a lot of debate over the coming months on a lot of subjects.

The market will likely continue to focus on unemployment, consumer and producer prices, and other bits of econo-data.

Meanwhile, they’ll continue to give little attention to the rate of consumer credit expansion – a.k.a. what actually matters. It’s the classic Wall Street habit of failing to see the forest through the trees.

But hey, that’s opportunity for us and why we’ll stick to our original strategy and take the most recent round of volatility in stride.

Basically, the Fed is going to keep the free money, reflation party going for the foreseeable future. They won’t be moving an inch until they see credit demand rebound, which could be many months away.

Until then, they can be as “creative” as possible and prevent deflation with “whatever means necessary” with few immediate consequences.

There will, however, be consequences…eventually.

That’s why we continue to buy on the dips, forget about the short-term volatility, and bet the Fed will keep the party going for longer than most everyone expects. All the while keeping in the back of our minds the true causes of the Great Depression and why this rebound, whether it lasts another week, six months, or two or three years, will go down as a giant bear market rally.

Good investing,


Andrew Mickey
Chief Investment Strategist, Q1 Publishing

-- Posted Monday, 21 December 2009 | Digg This Article | Source:


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