The Fed, Inverse Stagflation and Soaring Asian Inflation: A Bad Cocktail for Global Stocks in 2008

The U.S. Treasury market is coming undone in a big way after suffering one of its worst months in years thus far into June trading. Benchmark ten-year bond yields have climbed from 3.94% on June 6 to 4.26% recently as the Federal Reserve continues to talk the dollar higher and on the heels of better than expected May retail sales.

From its four year low in March yielding just 3.31%, T-bonds have suffered big losses over the last three months. And higher yields spell big trouble for an already badly damaged mortgage sector and several segments of the still fractured credit markets.

The ongoing ratcheting of U.S. bond market yields is bad news for the fragile economic recovery. It’s pushing consumer lending rates higher at exactly the wrong time. Higher mortgage rates combined with a sharp rise in unemployment don’t paint a pretty picture for a U.S. economic recovery later this year.

The benchmark 30-year fixed mortgage rate soared from 6.19% on June 6 to 6.41% recently – a bearish sign for those optimists hoping the mortgage market is stabilizing. In fact, residential real estate prices remain in a total freefall with no signs of bottoming. What’s really alarming about that number is that 12 months ago the same lending rate stood at 6.57% -- and that was prior to the July credit outbreak and the ensuing barrage of Federal Reserve interest rate cuts!

All housing indices, especially the S&P/Case-Shiller Home Price Index, continue to show accelerated declines across the country’s largest housing markets. Higher long-term rates will make this situation even worse and apply more deflationary pressure on the economy. The Fed, which controls short-term rates through the Federal Funds rate and the Discount Rate, does not set long-term rates; the latter are set by global market participants and is largely sensitive to inflation and economic growth trends.

The Fed has historically raised interest rates to cool inflation and subdue above-trend economic growth. Although inflation is certainly percolating, the economy is probably in recession since April while unemployment is rising and housing markets are still deflating. In normal economic times, these conditions would require additional Fed easing, not a rate hike.

Since April, bond market investors have driven long-term interest rates higher as inflation expectations continue to rise globally. Skyrocketing energy and food prices, which are mostly priced in U.S. dollars, has recently forced the Fed and the Treasury to verbally support the flagging dollar. Markets now expect the Fed to raise rates this fall to stave off inflation and halt the dollar’s seven year decline.

Sales at U.S. retailers in May were boosted by the government’s economic-stimulus package in late April. That spending spree surprised Wall Street causing bond yields to soar. But May’s retail sales weren’t organic or derived from real income gains as the majority of consumers are already tapped-out and consumer confidence remains at an 18-year low. Government checks were spent largely at wholesalers like Wal-Mart and Costco and not on discretionary items like apparel, furniture or vacations.

Meanwhile, LIBOR or the London Inter-bank Overseas Lending Rate is still in a state of flux.

LIBOR continues to remain elevated with three-month overseas dollar rates widening to 2.81% this week from 2.70% on June 6. And EURIBOR, or the Euro equivalent, is also stuck in the stratosphere trading at 4.96% -- way above the European Central Bank’s base lending rate of 4%. This is not good news for credit markets as it continues to point to reluctant inter-bank lending.

Other segments of the credit markets, though easing since the Bear Stearns rescue in March, remain problematic. Corporate bond yields are soaring again, junk bond yields are rising and auction rate securities are still clogged. None of this suggests the credit crisis is over. The only good news is several cross-border deals are surfacing again as the largest players have no difficulty accessing credit. But that’s an exception, not a rule.

If the Fed starts raising rates this fall, how is this possibly bullish for credit markets? Can the economy handle another round of tightening? I doubt it.

If the Fed has its hands full with energy and food inflation and rapidly plummeting housing values, Asian central banks have big problems of their own.

Asian inflation, at 7.5% through April, is close to a 9 ½ year high and more than double the 3.6% rate 12 months ago.

Central banks in Asia have an even tougher task of controlling not only escalating inflation but also soaring wages. Unlike the United States, where wages are still benign, Asian wage inflation is now in a bull market, pressuring corporate margins and instilling higher costs. Combined with a weak dollar, soaring inflation in the emerging markets is bad news for the global economy because China isn’t exporting deflation any longer; it’s now exporting inflation.

At some point, I’ve got to believe China and other countries in the region, including smaller markets like Vietnam, will totally lose their ability to control inflation. The food crisis and soaring prices for the grains will probably impact the labor market and productivity levels across the region.

How efficient can you possibly be when at least 50%-75% of your salary is directed to food costs and prices are spiraling well ahead of your wages?

The emerging markets are wrestling with inflation. But the story is more complicated in the mature economies.

The industrialized economies are facing a bizarre economic cocktail of 1970s-type stagflation mixed with rising deflation in real estate, domestic consumption and bank credit contraction. I coin this paradigm “inverse stagflation.” The Federal Reserve and other mature economy central banks continue to face an extremely challenging environment of soaring food and energy inflation combined with busted real estate markets in America, Spain, England and Ireland.

In my eyes, there’s no way the Fed will raise interest rates this year in the midst of rapidly spreading deflation across many parts of the economy, including labor and housing. This implies the dollar’s ongoing rally won’t last and the correction in bond yields since April is probably a buying opportunity for the economic bears, especially if oil prices are peaking, at least for the next 6 to 12 months.

As oil prices eventually decline at some point, inflation fears should ease, allowing the Fed to reduce rates yet again and probably support a bottom for stock prices later this fall. This is not the markets’ consensus at the moment. The market believes the Fed has a growing handle on the economy, inflation and the dollar. But I’ve got to believe that investors are too optimistic about the Fed’s ability to control inverse stagflation, arrest the housing bear market and encourage domestic consumption through even more borrowing. The Fed has not faced an economic paradox of this nature in the post-WW period. I have little confidence it can control both inflation and deflation at the same time.

This remains a bear market rally for stocks since late March and since May, a bear market rally for the dollar, which was brutally oversold. I’m sticking to gold, gold stocks, alternative energy, agricultural commodities, Asian currencies, global value blue-chip stocks that pay dividends and portfolio managers that specialize in making money when the stock market goes down, or hedging. This will be a rough summer. Brace yourselves.

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