Tomorrow, the Federal Open Market Committee (FOMC) meets to set their key rate.
From a central banking point of view, these are extraordinarily confusing and difficult times. We sympathize with FOMC members as they sit down to make what may prove to be one of their most important decisions.
[Editor's Note:The Mother of All Financial Disasters]
Today's Wall Street Journal (WSJ) has a headline, "Behind Buyout Surge, A Debt Market Booms, CLOs Spark Worries of Volatility and Risk; Loan Standards Loosen."
Our readers and those of our sister publication, Financial Intelligence Report, know we have already written extensively on this subject, including in our last issue.
Suffice it to say that a CLO (Collateralized Loan Obligation) is a massive bundle of bank loans, sliced and diced to spread default risk very widely and sold to investors, such as hedge funds, which are eager for high yield.
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As the WSJ reports, the volume of borrowing by CLOs more than doubled in 2006 to some $90 billion, up from some $45 billion in 2005, and looks set to rise further in 2007.
With CPI inflation still stubbornly above the Fed's "comfort level," the U.S. dollar near its historical low, and high-yield debt continuing to boom, the Fed would have been fully justified (as we have urged) in raising its key rate many months ago.
However, our Congress gave the Fed, not one mandate — to control inflation and thereby lend support to the dollar — but two mandates.
The second and often conflicting mandate is to encourage economic growth. And there's the rub for our Fed.
Facing a sluggish economy, frothy financial markets, and a looming housing bust, the Fed is under pressure to lower rates.
In addition to the economic pressures to lower rates, the Fed faces the risk of reverse leverage and a financial panic, should the "stealth risk" of credit derivatives come unwound.
The FOMC will doubtless also be aware that, in its June 24 Annual Report, the Bank of International Settlements (BIS) warned that the global economy could well be on the brink of a major depression similar to the one that happened in the 1930s.
[Editor's Note:Expert: Residential Real Estate Will Fall 20% to 40% -- Go Here Now]
Well, if ever there was latent fear at the Fed, that statement will fan it into an absolute dread of raising rates, possibly encouraging some FOMC members to push for a drop.
Finally, the Fed faces the political risk to our present Republican government of an increase in rates, in the face of a key Presidential election.
On the face of it, there are powerful reasons for the Fed to hold or even to lower rates.
However, Fed Chairman Bernanke is an anti-inflation hawk. He is concerned enough at the (Government-cooked) CPI. If he casts his eye at the more real, pre-President Clinton (when the cooking began in earnest) computation of inflation, he will be aghast to see the curve (a mirror image of the CPI) standing at 6 percent, some three times that of the "cooked" CPI!
This may caution him to urge his FOMC to leave rates on hold.
However, Bernanke will also know that the net purchases of U.S. Treasuries by foreigners (key to financing our massive government debt) slumped by a shocking 99 percent in the last reported month, to some $376 million, from some $30.5 billion the previous month.
The ability to fund our government debt is crucial.
We believe that a lessening of our Treasury's ability to fund its debt, in the short term the Fed may be forced to raise its rate, regardless of the risks of a spreading housing bust and recession.
[Editor's Note:Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets]
In today's frothy markets, with most media forecasting rates on hold and some even pointing to a reduction in rate, just imagine the systemic financial shock that would be caused by a rate increase on Thursday.
Now, we urge our readers please, to note that we are not saying that the Fed will raise its rate tomorrow, but that the pressures are mounting to the point that that the Fed may be forced to do so — despite the near panic repercussions in the political, economic, and financial arenas — in order to attract foreigners back into the U.S. dollar and into the vital U.S. Treasury market.
If the Fed does raise its rate tomorrow, or even announce a much tougher anti-inflationary bias, stand by for a deluge in stocks (which we feel are already "toppy", especially in financials and now that estimated net earnings are turning flat), in high-yield bonds, in mortgage/credit card defaults, and in most bonds.
At the same time, be prepared for at least a temporary rise in the U.S. dollar; in Treasuries (as investors flee to safety and foreign buyers are enticed back into that market) and in money market yields.
If interest rates rise and margin calls explode, we expect many investors to sell gold, at the margin, both to raise equity and to reduce higher cost leveraged gold holdings. In the short-term therefore, gold could fall further in price.
However, depending upon how the near financial panic plays out, gold could explode in price, in the fallout phase.
As we have long forecast this event, our recommendations to our most conservative investors change very little, to be in a strong cash position, to diversify globally into high performing global value stocks, to allocate U.S. equity investments into core sectors such as health care, and, of course, a small percentage in the greatest insurance policy, that is gold.
Finally, we recommend that our more adventurous readers who are still riding these frothy markets — raise their level of attention to very, very cautious and think of both reducing margin and the purchase of put options.
Note: We discovered an error in yesterday's email "Stealth Risk Unraveling" in a reference to the Economist. It should have read, "According to the Economist, the total value of residential property in just the developed economies increased by $25 trillion to some $70 trillion (up 50 percent) over the past five years."
Editor's note:
Expert: Residential Real Estate Will Fall 20% to 40% -- Go Here Now
The Mother of All Financial Disasters
Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets
Buffett: The best book ever written on investing.
