Dow+32.73up+0.29%
11,220.96
Nasdaq-3.16down-0.14%
2,255.88
S&P+5.48up+0.44%
1,242.31
Stock Strategy © Getty Images

The Amateur / Vad Yazvinksi7/2/2008 12:01 AM ET

Our newest outsourcing trend: Monetary policy

"Promises are like babies: easy to make, hard to deliver"

--Author Unknown

Here we go again. Ben Bernanke and Company last week delivered another strong message to the commodities bears all around the world -- "we can't really tell if it was or is a bubble until after it blows up." Unfortunately, it does seem as if my last week's prediction about the Fed's inability to raise rates in the middle of the political season is actually becoming a reality.

Faced with a tough tradeoff between growth and inflation Bernanke came up with a clever -- but also potentially dangerous -- way of solving the dilemma. The solution would be to outsource the inflation-fighting role to other economies around the world instead of doing the dirty work themselves. In his speech last week, Fed Vice Chairman Kohn delivered a message that seems to have not only borrowed major points from the stories of the commodity bulls, but also gave a pretty clear answer to the question of whether they will really raise interest rates in August: "Not gonna happen!"

"The reasons for the trajectory and persistence of increases in prices of food and energy this year, as global growth has moderated, are not entirely clear. The upward trend in prices of food and energy over the past several years, however, importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities.

Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability."

The translation basically goes like this: "U.S. monetary policy has nothing to do with ever rising commodity prices. These high prices are merely an indication of sky rocketing demand from BRICs (Brazil, Russia, India and China). And because the U.S. Federal Reserve and the U.S. economy have had nothing to do with this rise, they should not be obligated to participate in the clean up. The new guys on the block and stubborn Europeans need to fight the inflation battle on their own by slowing down economic growth engines using all means necessary – by raising rates, further adjusting currency exchange rates, etc. The U.S. won't be raising rates any time soon. Case closed.

The market’s reaction? The Dow Jones Industrials ($INDU) went down 400 points or so (establishing a new multi-year low), gold was up $50, and new highs were hit for crude oil -- setting a virtual death sentence for some (or all?) the big three U.S. auto and R.V. and boat makers. I certainly admire the creativity of this "heads I win, tails you lose" interest rate logic -- it is almost guaranteed to win some political points here at home. But it is also a very dangerous one for the world economy. Relying on China and India to remove the excess liquidity from the world's economic system is in my mind equivalent to a firefighter waiting on his colleagues to return from vacation in another state to help him put out a house fire that has already been raging for a while. It is very possible that by the time they come back, there won't be a house to save.

It was just a few months ago when Wall Street put out an "all clear" sign for U.S. equities with "always" optimistic analysts predicting a "high double digit" rebound in earnings for the latter part of 2008. The Fed cheerfully predicted that inflation expectations will remain well-anchored and thus are not of a particular concern. Unfortunately, recently the situation took a rapid turn for the worse with M2 Money Supply growth skyrocketing into double digits. Excess liquidity had to end up somewhere and ever-rising commodity prices offered a very safe refuge.

So instead of already being out of what could have been a relatively minor recession absent the rate cuts, we are now possibly only one hurricane away from oil prices clearing the $150 a barrel barrier and with it GM (GM, news, msgs), Ford Motors (F, news, msgs) and major U.S. airlines rapidly entering the insolvency territory. But even with all U.S. indices now closing fast on "bear" market territory, the stubborn Fed still refuses to do its main job of fighting inflation, and keeps arguing that its lax monetary policy has nothing to do with high prices.

Come on Ben, give me a break. M2 Money supply growth in double digits during the first quarter of 2008 got very close to that of China, a country whose GDP is growing at 10 times the rate of the U.S. Where do you think this liquidity has gone?

Anyway, enough rambling – the Fed has made its decision, and while I think it was not a very smart one, I have to now figure out how to profit from it. My healthy short position has certainly helped me to preserve most of my gains, and being some 15% plus ahead of the market is definitely a terrific result so far, but now I need to figure out how to resume the upward trend.

I don't know what it might be, but absent a rate increase move from the Fed, oil and other commodities could very well go higher and when and if that happens U.S. indices could possibly now go much lower -- say another 7 to 8% lower. Plus with the U.S. Fed outsourcing the interest rate increases work to the emerging markets and the European Central Bank, these markets could actually fall faster and harder than anyone expects. This sell-off is also likely going to produce some terrific buying opportunities, and thus with capital preservation goal as a major theme, I'll for now buy deeper into the defensive utilities and health care sectors…

I hope that I am completely wrong, but it certainly does not look pretty out there- with Volatility Index (VIX) nowhere close to the "fear" territory, capitulation of the major indices looks likely to continue for a while longer, so stay safe out there. As always, you can reach me at skepticalcapitalist@gmail.com.

Note: Neither Vad Yazvinski NOR skepticalcapitalist.com are investment advisors and they do not endorse or recommend any securities or other investments. Yazvinski and any entities affiliated with him have in the past and may be in future actively trading the securities mentioned in this article. At the time of this writing, Yazvinski has held beneficial interest in most securities mentioned in his MSN Strategy Lab portfolio.

Rate this Article

Click on one of the stars below to rate this article from 1 (lowest) to 5 (highest). LowRate it 1Rate it 2Rate it 3Rate it 4Rate it 5High