Mid-Year Forecast - More See-Saw Fed

John Mauldin | Thoughts from the Frontline
July 15, 2005

Where will Treasury rates go? What about inflation/deflation? The dollar? The stock markets? Gold? We cover all this and more in this week's letter.

I normally do an annual forecast at the beginning of each year. In conversations with a number of clients and readers, I've come to realize it might be helpful to do a midyear forecast as well.

In January, I suggested that 2005 would be the year of the See-Saw Economy. So far, with one major exception, my forecast is in the middle of the fairway. I wrote:

"We are all familiar with the see-saw. Who among us did not play upon one as a kid? See-saws work as long as both partners work together. Indeed, with the proper cooperation, they are quite fun. However, there are more than few of you who let your partner get to the top of his ride and then jump off, allowing him to drop to the ground. I, of course, never did that to my younger brother.

The world is in a kind of see-saw economy, precariously balanced between a US trade deficit and foreign central bank buying of US treasuries. In general, I think the game continues though 2005. It is in no one's best interest to stop the game. It should be another good year for the economy, but we are getting closer to the endgame, when one partner decides they are doing all the heavy lifting and the other partner is just along for the ride."

I called for stocks to go sideways, treasuries to go down to flat, the dollar to strengthen (it was WAY oversold) and then resume its downward path, and for the Fed to continue to tighten. And Fed policy is a good place to begin.

The See-Saw Fed

I wrote the following the first week of January:

"...I think the Fed keeps on raising rates, with perhaps a pause or two, until it gets to at least 4%. Their history is that once they get started, they do not stop until there is some pain. Since the signals of 'pain' tend to lag, it is quite possible the Fed tightens too much before it stops...

"The Fed is going to continue to raise rates until the economy shows signs of trouble. While the Fed in the past has been willing to cause a recession, I do not think this Fed will do so. They are on the See-Saw between worrying about inflation and creating another speculative economy with interest rates too low and the concern that raising rates too much will squeeze the growth out of an economy that has grown addicted to, if not fat upon, - maybe even dependent upon - low interest rates.

"One Caveat: if long term rates do not rise, the Fed will stop sooner than 4%. They will not create an inverted yield curve on their own."

The Fed still has the same problem they had in January, only we are six months closer to the end of this tightening phase. They are almost certainly going to tighten another 25 basis points at the August meeting. The question at that point becomes whether or not they will change the language in their release which comes at the end of the Fed meeting. Will we lose the word "measured?"

I think we need to acknowledge that the bias among Fed members, at least if I'm interpreting their speeches correctly, is to continue tightening. But it may be time for them to change their tune. Here are the main issues facing the Fed.

There are some arguments that can be made for raising rates. Clearly, the low rate environment has fostered a significant rise in the price of homes, if not a housing bubble in certain areas. The Fed, as they should be, is concerned about adding fuel to the flames. Allowing a real housing bubble to develop because of an overly stimulative Fed policy would create real problems when it burst. Significantly falling housing prices in the US is a problem that the Fed has few, if any, tools to deal with.

When housing bubbles burst they are generally accompanied by foreclosures and thus oversupply on the housing market. Because of the large number of houses that are being bought for investment purposes with little or no money down (in some areas as much as 20% of homes are bought for investment/flipping purposes), a cycle of foreclosure would be difficult to stop with interest-rate cuts alone.

I continue to refer to a speech Greenspan gave two years ago. He said the Fed should set its policy so as to insure that significant damage is not done to the economy. Rather than try to micromanage every little part of the economy, it was better to worry about the biggest risks which would cause the most damage and use policy to avoid those risks. "First, do no harm."

I could spend the whole letter listing risks to the economy. But at the top of that list would certainly have to be a bursting of the housing bubble. Thus, continuing to raise interest rates at a measured pace in the hopes of slowing the rise in home values and letting a little of the air out of the bubble certainly has to be in the mind of every Fed Governor.

Further, the economy is in relatively good shape and from their speeches they believe that the good times continue. Headline unemployment is down to 5%. The US government deficit is coming down as tax receipts are way, way up. (Now if Congress could only show a little discipline and stop spending!) Corporate profits, both as a percentage of GDP and on an absolute basis, are at an all- time high. Corporations have significant cash reserves.

The stock market, while not exactly in a bull run, is doing fine. Price-to- earnings ratios can come down in several ways. Either the price of the stock drops, or the prices stay flat and earnings increase. We've seen the latter for several years. This is a much better way to get to low valuations than a recession. (See more below.)

Consumer confidence is rising. Unemployment insurance claims have dropped significantly over the last two years. Total home sales are strong and getting stronger.

As noted above, the tendency is for the Fed to continue to raise rates until there is a little pain. Looking at the data above certainly suggests they will continue to raise rates in the fall.

Treading Water

But if the principle is "first, do no harm" then you could also make a strong case that the Fed should stop raising rates after the August meeting.

First, it is not altogether clear that raising short-term rates will have any real effect on long-term rates, and thus on mortgage rates. It certainly hasn't had much of an effect so far. As I noted last January, I don't think the Fed wants to create an inverted yield curve by purposely raising short-term rates above the 10-year note.

And there are questions about the real strength of the economy. Unemployment may not be as good as it sounds. The current low U.S. unemployment rate probably understates the true level of joblessness by 1 to 3 percentage points, says Katharine Bradbury, the senior economist at the Boston Federal Reserve. Millions of potential workers who dropped out of the labor force during the recession four years ago have not returned as expected and are thus not counted in the official unemployment statistics. (http://www.bos.frb.org/economic/ppb/2005/ppb052.pdf)

Inflation is low, which is a good thing, unless you have a recession. Core inflation is below 2%. If you look at the personal consumption price index, core inflation is only 1.5% and that is the index the Fed generally prefers to look at.

There are many observers who think the economy will soften in the latter half of this year. I agree. But please note that soften is not a recession. But raising rates while the economy is in the process of softening can help bring about a recession. And a recession today (or an economy only growing 1-2%) with inflation so low would almost certainly bring back the deflationary scares of 2002. The 10-year note could drop to 3% and mortgages would go to 4%. What such a scenario would mean is open for debate, because I can argue at least three scenarios forcefully, and another 2-3 that might be of interest. It would create a lot of uncertainty. Markets HATE uncertainty.

There are other suggestions that the economy is softening. The ISM manufacturing index is in a downtrend that is worrisome. The May new job numbers came in much lower than expected, with many of the new jobs in low-end services and a guesstimate as to new businesses formed, which was the bulk of the new jobs. Making Fed policy on bureaucratic guesstimates is not the best course. The index of leading economic indicators from the Conference Board has been dropping and is suggesting the economy will slow in the next 2-4 quarters.

Oil and energy prices are beginning to have an effect upon consumer spending and are certainly a drag on growth.

On one side of the see-saw is the potential for the housing market to do well and truly overheat. On the other side is the potential to tighten too much in the face of a softening economy and maybe push the economy into recession. That would also not be good for housing and would certainly bring us closer than we would like to outright recession.

I think the prudent thing to do would be for the Fed to signal they are going to pause in their rate hike drive for a meeting or two while they keep a sharp eye on the economy to make sure things don't get too hot. They don't want to signal that all chances of more rate hikes are over, as that would create a new set of problems, and neither do they want to suggest they are concerned about economic growth. The press release after the next board meeting in August may be the most important we have read in many years.

What I think they will do is look at the economic numbers, and especially the jobs reports, to see how the economy is doing. If we get strong reports, look for them to tighten more. If we see signs of weakness, look for them to pause.

Whither the Stock and Bond Markets?

I expect more of the same, which is to say sideways for the bond market. If the Fed pauses, then we could see a nice rally in the stock market and then a retreat as the market becomes aware the Fed paused because of a softening economy. Caution in both of these markets is the order of the day. I hate to keep repeating, but we are going to get to buy this stock market (and refinance our mortgages) in the middle of the next recession at a significant discount. But that might be several years. Or not. Making realistic projections beyond about 6-9 months is just not possible. There are way too many variables. Yet, I don't see the economy going into recession in the next 6-9 months.

As an aside, if we have a slowdown like we had in the middle of the 80's and 90's and then do not have a recession for another 3-4 years (a possibility), we would not need two recessions to get us back to low P/E valuations and a resumption of a real bull market. One would probably be enough. While this is not my most likely scenario, it is one that must be considered. And frankly, it would be the least painful. I will deal with this more next week, as part of a discussion on trade deficits.

Then one area I really missed it my annual forecast was on the euro. I thought it would continue to rise, as I repeatedly said since early 2002 (one of my better timed calls - every now and then I get lucky). I did issue a mid-course correction to in April, not too far from the top, as things changed and I thus I changed my view on the euro. I am now getting bearish on the British pound as well, though for different reasons. Count me a selective US dollar bear. I would make my dollar bearish long term currency plays on the Asian currencies which float against the dollar.

For all the reasons I have written about over the past months, I am still bearish on the euro. Until they sort out the issue of just exactly what is Europe and how it should be run, there is just too much pressure on the currency.Further, all those central banks which bought the euro in 2004 as a way to diversify probably now wish they hadn't.

As for gold, I expect it to rise in dollar terms over time, but nothing like we have seen the past few years. Oil needs to correct. The longer it doesn't, the more it will drop when it does. I am still a long term bull on energy, but enough is enough. I would like to see a healthy correction and then on to the next bull leg.

That will be all for this week. Its summer and this is long enough. Next week, we will look at the trade deficit and Chinese policy.

Bull Hunter, Yankees, Bulgaria and Points Beyond

My good friend Dan Denning has a new book out called Bull Hunter. As you can imagine from the title, it is built around the premise that there is always a bull market somewhere, and Dan writes an easy to read tome telling you how to find it. Dan is the editor of Strategic Investing, and spends a lot of time traveling the world looking for deals and finding investment themes that make sense. He mentions very specific funds and stocks in the books and gives his firsthand experience of India and China. You can get the book at your local bookstore or for a 34% discount at www.amazon.com.

I leave for Europe and vacation in about 9 days, and then I am back for the month of August, except for maybe a quick trip here or there. But this fall the travel schedule is starting to look busy. I will be in Toronto and several other Canadian cities in September. I fly to Europe in the early part of October, where I will be in London, Brussels and Denmark, and make a quick trip to spend a weekend with long time friend, Phil O'Rourke, in Bulgaria. Phil (for whom the word raconteur was invented) has been literally all over the world on various business ventures, and he is singing the praises of Bulgaria, so I am going to take a few days off and find out why. I am sure we will see a few other countries while I am there as well.

Then I come back and do the New Orleans Investment Conference October 30- November 3 and then fly up to Detroit. More on the conference in later issues. It is going to be a lot of fun and has some very high-powered speakers. New York, Chicago, Houston, and San Diego are all on the schedule. I will give you details in a later letter.

While I enjoy going places and meeting people, the actual air travel is just not fun anymore. And Southwest Airlines is not helping. Yesterday, I had to make an emergency trip to Tulsa. I took the first flight out, buying my tickets at the counter. I got my boarding pass and made the flight, did my business in Tulsa and then went back to the airport. I stood in line to get my boarding pass, and they asked for my ticket. It seems they had given me a ticket that morning. When was the last time you got an actual physical ticket? It has been years. I thought it was just the receipt and left it in the airplane or gave it to them when I boarded. I don't know. But no one told me we had gone back to the 90's and had an actual physical ticket. I fly a lot on Southwest and haven't had a physical ticket in years.

Despite my protests, Southwest made me re-purchase another ticket to fly back. They said that ticket was just like cash. Of course, it had my name on it and you had to show an ID to use it, but that logic did not prevail. The very first person I told about it when I came back said the same thing happened to her last year. Now we know why Southwest is so profitable. There are less peanuts in the packet combined with legal extortion. Oh, well. Their flights are cheap, their people are friendly, but sometimes you would just like a little love.

Speaking of flying, next weekend the whole family (seven kids and a daughter-in- law) are off to Paris, Ouzilly (at Bill Bonner's chateau and with his six kids and a gaggle of relatives - should be a lot of fun) and London. Dad is flying coach. I know, that may not seem like a big sacrifice to some of you, but this old back really prefers business class (or first) on American, my favorite airline. 3,000,000 miles and counting. And they never double charged me for a ticket.

The Yankees are in town next week, and we will have a party or two at the Ballpark office, watching the game, eating sushi (we bring in this fabulous chef from Piranhas in Arlington) and finding an adult beverage or two. Lots of old friends and new friends. I get to meet Louis-Vincent Gave from Hong Kong, plus Jon Sundt and Dick Pfister from Altegris will be in for a few games. Life is good. Since it is doubtful we will actually be playing in October, you have to make do with what you have. And when the Yankees are in town it is always fun.

Have a great week, and find some friends and an adult beverage and tell a few stories. You will all be the better for it.

Your taking yet another securities regulatory exam on Monday (is there no end?) analyst,

Scroll down for comments.