More Signs are evident that the 50 Basis Point Rate Cut ...part 3
...was not only unnecessary but could result into elevated economic problems in the future – Part 3
The 50 basis point Fed rate-cut on September 18th send the already pressure U.S. dollar into a free-fall and it reached all-time or multi-decades low against a basket of global currencies.
Commodity prices, which are prices in U.S. dollars, soared to record highs and continue to trade at those record levels ever since then. Suggestions that the Fed may cut again will, among other things, continue to put upward pressures on commodity prices, hard as well as soft commodities.
The elevated prices of commodities will likely result in an increase in inflation as well as inflationary expectations. Although commodity prices will fuel head-line inflation and have limited or no effect on core inflation it is a factor which should not be ignored.
Companies face increased input price pressures among several sectors. Prices Paid components continue to remain at elevated levels according to the Empire State Index, Philly Fed Survey and ISM Non-Manufacturing Index. The NAPM-Chicago and the ISM-Manufacturing Index showed signs of improvement but the recent surge in commodity prices should reverse that trend.
Companies will have two choices how to handle the increased costs. The first choice is not to pass on the higher prices to consumers and accept lower margins and profits; the second choice is to pass on those prices to the consumer and fuel inflation and inflationary expectations.
Either choice will be a major headwind for the economy and the equity markets. The economy is faced with potential wage-based inflation as well as the high potential of a surge in commodity-based inflation despite sub-trend economic growth.
Treasury yields, on the long end, have moved in the opposite direction which the Fed has expected and it seems that treasury markets and the equity markets paint to different pictures.
One market has it wrong.
The gold market, a market investor’s crowd amid economic uncertainty and inflation fears. Gold has broken out to the upside and trades at multi-decades high.
The elevated commodity prices both hard and soft, the tight labor market in the U.S. which continues to experience wage-pressures across several sectors as well as signs of problems in the private non-farm payroll sector, the continued fall in the U.S. Dollar and the negative effects on other parts of the economy, the break-out in the gold market, the behavior of the treasury market, continued pressures in the housing sector which is likely to deteriorate and problems in the credit markets which may increase due to recent Fed action despite the reasons given by the Fed in the FOMC minutes together with the possibility of weak third-quarter earnings and more important the risk of below-expectation fourth-quarter guidance should all give reason to question the recent rally in global equity markets and may be the final attempt of this long bull-market.
Another risk is that consumer spending especially during the upcoming holiday-shopping season will be sub-trend and will give further reason to caution the current economic expectations as well as the economic outlook.
Investors seem to continue to ignore all negative aspects and the potential threats to the global economy. The majority of the investment community and the Fed cheer the recent Fed action in regards to the aggressive rate-cut but ignore the possible negative impact of the short-term attempt to calm the credit crisis and lend support to the housing markets.
The risks are embedded in the economic pipeline and should not be ignored by investors.
Some investors who wanted the Fed to act sooner now argue that the rate-cut is too late and the economy is at increased risk of a recession. If a full blown recession will be avoided a period of stagflation should not be ruled out.
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It is not smart to play it safe but it is safe to play it smart.
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