Bill Fleckenstein

Contrarian Chronicles7/10/2006 12:00 AM ET

Why the Fed is really done

The Fed wants to be loved. It doesn't want to be the tough cop. So it's done fighting inflation and the rate hikes are over. That's started a rally, but it won't last.

By Bill Fleckenstein

Let's talk about the Fed, shall we? Since, for the moment, what it may or may not do next drives so many markets, I'd like to share my expectations about the Fed's future activity.

'Weaker-economy' wand hides inflation

My belief is that the Fed really didn't want to tighten one more time as it did last month, but it was forced to because various markets had essentially been "laughing" at it. Now the Fed thinks it has reclaimed its credibility by scaring markets with its tough talk. If the economic data begin to show clear signs of a slowdown (which is what I anticipate), the Fed will feel comfortable proclaiming that weaker economic activity will slow inflation down.

As I have said, I don't believe that the Fed is really worried about inflation at all. But I do believe that the Fed will be extremely concerned about the economy as it slows. Fed chairman Ben Bernanke has his deflation fears, and above all else, we must remember that the Fed is run on the applause meter. Fed members just want to be loved. I think that is the most important thing to keep in mind.

None of these central bankers have one shred of former Fed Chairman Paul Volcker in them. If that were the case, they would have done something about inflation long ago, instead of hiding behind their pet inflation statistic, which purports to show that there isn't any (thanks to various and sundry "calculated" distortions).

A banker who brooks no bubbles

One central banker who understands inflation in its various forms is First Deputy Governor Eva Srejber of Sweden's Riksbank -- who, in a speech last week about asset bubbles, showed that the applause meter has no place in the responsible conduct of monetary policy:

"Those who maintain that there is too much uncertainty to dampen (an asset) price rise via interest rate adjustments are thus of the opinion that it is better to wait until a correction of abnormally high asset prices is a fact, and take action then. Many believe that it is important in such a case to act forcefully, so as to prevent a deep recession.

"However, in my opinion and that of others, the risk of such an approach is in overdoing it and thereby delaying a necessary adjustment of balance sheets and debt levels. New imbalances in other markets could then arise, and the process will begin again. When the situation turns next time in other asset markets, there is a greater risk of reaching the zero-interest rate level. Many central banks have acted in this way, which may be the reason why a house-price bubble has been created some time after a share price bubble."

Longtime readers know that Eva and I are on the same page. It's refreshing to find a central banker somewhere who is capable of recognizing the facts -- and willing to stand up publicly and call a bubble a bubble.

The tableau reeks of finito

In any case, my expectation is that, barring some stunningly strong economic data, our central bank is done with its rate hikes. That ought to allow equities to rally for a little while, especially given all the angst in evidence before the June Federal Open Market Committee meeting.

But the rally may play out in fits and starts, and it will certainly be impacted by economic data that are either hot or cold. Then we'll be into earnings season. I expect a number of technology warnings for the third quarter, and that may be the catalyst for stocks to start declining again.

Hockey sticks that can stick it to shorts

On the other hand, bullish psychology has trumped fundamentals for so long that the bulls may try to say: "Oh, we can ignore any weakness we see here, because that was related to Fed tightening. And, since we think that's over, we can anticipate better times ahead."

In other words, for a short time, the bulls may get away with rationalizing the weak economic data as a rearview look -- choosing to dream instead about hockey-stick-shaped recoveries. That will be just a fantasy, but the market can "trade" fantasies for a while.

That brings me to the subject of maneuvering around rallies. It's what one must do when running a short book, as I am. As part of my defensive "footwork" -- to balance the risks on shorts that I didn't want to cover (i.e., Intel (INTC, news, msgs), SanDisk (SNDK, news, msgs), Lam Research (LRCX, news, msgs)and NetLogic Microsystems (NETL, news, msgs)) -- I recently purchased some calls on a stock that has been one of my favorite shorts: Research In Motion (RIMM, news, msgs).

Rationale for renting RIMM

I haven't been short Research in Motion since before the company announced its December quarter. I'd always planned to return to it as a short after the quarter just announced on June 29 was out of the way. My reasoning: Now that the patent-infringement lawsuit brought by NTP was over, that quarter would see Research in Motion make the number, beat the number and chirp "onward and upward." (Which is pretty much what the company said on its earnings call.)

It's very unusual for me to own something that I hate, because generally when it goes a tick against me, I run for the hills. In this case, I have my risk pretty much controlled, and I know why I am renting the stock. Given how much Research in Motion is loved, it could go for a bit of a sprint if the tape overall can put together the decent-sized rally that I expect.

But I am looking forward to the rally in stocks overall running its course. Then, I can sink my teeth back into Research in Motion on the short side, as well as re-establish my other shorts, probably in the most aggressive manner I have in quite some time. The big question is whether that moment will be in two days, two weeks or a month. We will just have to see how events unfold in terms of trying to ferret out that timing.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckenstein Capital Web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. At the time of publication, Fleckenstein was long Research In Motion calls. He was short Intel, SanDisk, NetLogic and Lam Research.

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