As Fed Debates Inflation Risk, Markets Just Want to Party
Companies:The Hershey Company Common StocTopics:Economy, Government & Policy.Related Quotes
On Friday April 1, 2011,
As the Federal Reserve escalates its inflation warnings, investors are paying little heed, driving stocks higher despite the threat that the central bank’s liquidity party may be coming to an end.Friday brought a fairly strong labor report to piggyback on some other improving indicators recently. This came while the Fed’s inflation-wary presidents have made the rounds to warn that interest rate hikes could happen soon-perhaps sooner than investors would like.
But the market paid no mind: An aggressive 2011 rally continued in stride as investors bet that the Fed would not be daunted by the inflation threat and instead would carry on its easing programs as long as possible.
„The level of concern about inflation is pretty high…but the Fed is pumping so much money into this market, at this point people just don’t care yet,“ said Matthew Tuttle, president of Tuttle Wealth Management in Stamford, Conn. „Right now the market’s just brushing everything off. The markets don’t care about anything.“
Richmond Fed President Jeffrey Lacker was the latest to warn that the central bank may find its hand forced soon. He told CNBC Friday that the Fed could raise rates before the end of the year, particularly if companies aggressively start passing on swelling input cost increases, such as from soaring commodity prices, to consumers.
„Should that become widespread and a widely accepted phenomenon, we could see core inflation ratchet up pretty significantly,“ Lacker said in a live interview. „You want inflation up a little bit but not too much, and I think there’s a real risk of overshooting in that process…The next nine months is going to be critical for us.“
But Fed Chairman Ben Bernanke finds himself in a ticklish situation.
Market rallies have followed a pretty straight line with Fed intervention. When the central bank implemented its program to buy Treasurys and other debt-a process known as quantitative easing, or QE-the markets rallied. When the Fed stepped back, is it did in April 2010, the market fell.
So fighting inflation comes at a cost, both political and economic, that Bernanke may be loathe to pay. Since launching the second leg of easing, or QE 2, the Standard & Poor’s 500 has rallied about 28 percent. QE 2, though, is scheduled to wrap up in June, and investors are anxious to know what the Fed’s stance will be afterwards.
„It would be silly to think that Ben Bernanke would stop QE 2 and then immediately start draining liquidity,“ said Michael Pento, senior economist at Euro Pacific Capital in New York. „He’ll wait at least two to three quarters before draining the size of the balance sheet. Then when he starts they’ll be baby steps. So he’ll be assured of being behind the curve of inflation.“
To hear some opinions, the market seems to want Bernanke to err on the side of easing.
„We’re going to see some inflation but it’s not going to be crazy…We’re hoping that the Fed just realizes (that) and does nothing for a little longer,“ Michael Sansoterra, managing director at Silvant Capital Management, in Columbus, Ohio, told CNBC.
Though inflation pressures are clearly building-just this week Hershey (NYSE:HSY – News) said it was raising prices nearly 10 percent-the Fed ironically may be able to use the otherwise-strong jobs report to fend off calls for tightening. Annual wage growth was just 1.7 percent, and some economists believe wage pressure is a critical component for inflation.
„[T]he fly in the ointment in today’s report was weak wage inflation, which means it is still probable that the Fed goes later relative to current market expectations,“ Neil Dutta and Ethan Harris, economists for Bank of America Merrill Lynch, wrote in a note to clients.
And should the Fed start changing course, it actually could be the bond market that takes the first hit as rates rise from artificial lows and start eating at fixed-income principal.
„For bond investors, they’re in a huge bubble,“ said Rob Lutts, chief investment officer at Cabot Wealth Management in Salem, Mass. „The valuations in bonds are just as extreme today as in 2000 for tech. The valuations on short-term Treasurys and even the 10-year is not rational in this environment.“
Lutts said the 10-year yield should be trading around 4.50 percent and possibly more, a full percentage point from the current level.
Should that sentiment take hold and bond vigilantes start selling as Washington refuses to address its debt, deficit and inflation problems, Euro Pacific’s Pento thinks the situation could get out of hand and beyond Bernanke’s control.
In that case, investors could find themselves in steep trouble.
„If he wants to be a winner what he’ll do is raise interest rates, drain the balance sheet and restore sound money to this country,“ Pento said. „He’ll have a very serious problem with GDP in the short term, but on the other end of that we’ll have a sustainable recovery.
„If he continues this level of monetization, if he keeps the balance sheet where it is and interest rates low, we’re going to have another crack-up and a severe depression.“