Fed Chairman Wrong Again?

When it comes to bonds and the economy, weve got a real slugfest going on.

Its a battle of epic proportions. In one corner, we have weak economic growth. In the other is inflation. And officiating the bout is none other than Federal Reserve Chairman Ben Bernanke.

First, lets talk about Wall Streets favorite prize-fighter: Economic growth. Based on the latest round of indicators, Id say growth is huffing and puffing.

Three of the signs

Weak retail sales: Chain store sales fell 0.6% in the most recent week. Theyre rising just 2% year-over-year now, the smallest rate of growth weve seen in 17 months. Plus, overall retail sales dropped 0.1% in June, the worst reading since February.

A collapsing housing market: I have been predicting this for months on end. Now, even the most wildly bullish analysts cant ignore the numbers. Theyre downright terrible.

The National Association of Home Builders puts out a monthly index measuring buyer traffic levels, current sales and expectations for the future. It plunged another 3 points to 39 the worst reading since December 1991. Meanwhile, June housing starts dropped 5.3% from May and 11% from June 2005. Several home builders are reporting shocking new orders declines of 40% or more!

A fully inverted yield curve: This may sound like economic hocus-pocus, but its something you need to understand.

Normally, short-term interest rates are lower than long-term ones. That makes sense. After all, as a lender, youre taking on more inflation risk by extending a 10-year loan than a 1-year loan. If inflation pressures rise and overall interest rates climb, you can get stuck holding an old 10-year loan that pays you just 5% when new loans are being made at 7%. No lender wants that.

However, right now, short-term rates are higher than long-term ones. In fact, the federal funds rate, at 5.25%, is the highest rate in the entire bond market (10-year notes recently yielded 5.03%).

What does this unusual situation mean? Its generally a signal that bond buyers expect a recession.

So, growth looks weak at the knees. Meanwhile

Inflation is coming out swinging.

In June, all three major inflation reports showed powerful pricing problems

Import prices: Overall import prices climbed 0.1%, after a 1.7% rise in May. That may not look like a heck of a lot. But oil and gas prices were slumping in June. Since then, theyve started rising again, with crude briefly touching a record level. That means Julys inflation stats will likely look worse, not better. Non-fuel import prices jumped 0.7%, tying the record high monthly increase set in May.

Producer prices: The Producer Price Index jumped 0.5% in June, almost twice what the market expected. Year-over-year wholesale inflation is red-hot … up 5%.

The core PPI is also rising at 1.9%, a rate we havent seen in a long time. Thats a sign of significant inflation pressure in the pipeline.

Consumer prices: The Consumer Price Index rose 0.2% in June, pushing the year-over-year inflation rate to 4.3%. Once again, that was in a month that gas and oil prices dropped. You can expect headline inflation to look worse in July thanks to surging prices at the pump.

The all-important core CPI rose 0.3%, and the year-over-year increase accelerated to 2.6%. We havent seen core inflation this high since February 2002. Talk about a big, red inflation flag! Lets not forget something else, either: Most people seem to think that you cant have both a slowing economy and rising inflation. But history proves you can. Its called stagflation, and it plagued the U.S. throughout the 1970s.

Indeed, the very latest, hot-off-the-presses data points to such a scenario:

The Philadelphia Fed Index for July dropped to 6 from 13.1 in June. That was weaker than expected, reflecting drops in orders and shipments.

But both the prices paid and prices received indices rose. This is as close to real-time data as you can get, considering July isnt even over yet.

Bernanke Trying
To Play Referee

Right in the middle, wearing the black and white stripes, is Bernanke. This week, in his testimony before Congress, he tried to persuade the public that the slow-growth side has the upper hand.

On Wednesday, he told Congress,

A sustainable, non-inflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past three years to a pace more consistent with the rate of increase in the nations underlying productive capacity.

The anticipated moderation in economic growth now seems to be under way.

The economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level over the medium term.

In other words, he took the Alfred E. Neuman approach to the latest inflation numbers, saying, What me, worry?

But is he right? Have we seen inflation peak?

Id argue that the Fed hasnt been right about much of anything in the past few years …

Blooper Reel Is Full
Of the Feds Bad Calls

Fed officials have consistently downplayed the risk of rising oil prices. They claimed over and over that energy prices would likely stop going up or at least moderate. That was dead wrong!

Former Chairman Alan Greenspan famously trumpeted the value of adjustable-rate mortgages in a 2004 speech … right before one of the longest Fed tightening cycles in history got underway. Anyone who took out a short-term ARM as a result has gotten crushed. Another wrong move!

Then theres the recent surge in inflation. Fed officials didnt forecast anything like the inflationary spike were seeing. And now, theyre saying not to worry about future inflation … even though they completely missed the past run up?

Something else to think about: The U.S. isnt the only major world economy. Check the scorecard

Europe makes up a bigger chunk of the global pie, and its still pumping demand.

Japan is in the midst of its strongest economic boom since World War II.

And China? Its economy is exploding. Gross Domestic Product surged 11.3% in the second quarter, the fastest rate in a decade.

Im not the kind of person who just covers his face and ignores data that doesnt conform to my views. If conditions change, and its time to declare a victory for the weak economy corner, Ill be ready to buy bonds.

But if youve been betting with the Wall Street no-more-rate-hikes crowd youve just been getting beaten up, bloodied, and bruised.

From my ringside seat, it doesnt yet look like inflation is down for the count. So, Im still not a long-term bond buyer. And I dont think you should be, either.

One other thing: If youre in higher-risk bond investments like junk bonds or, heaven forbid, sub-prime mortgage debt sell, and dont look back.

Until next time,

Mike

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About MONEY AND MARKETS

MONEY AND MARKETS (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Colleen Collins, Amber Dakar, Ekaterina Evseeva, Monica Lewman-Garcia, Wendy Montes de Oca, Jennifer Moran, Red Morgan, and Julie Trudeau.

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