Thursday, December 07, 2006

Hot Markets

Aren't we all having a time of our lives?

There is one article posted on Safehaven:
Warning Shots and Spin. It's written by Steve Saville from www.speculative-investor.com.

Highly interesting piece and the point in which he mentions the sharp correction Saudi Arabia's Tadawul Index is really as a good warning as any. Look at his posted chart. See how it has broken sharply to the downside over the past several weeks?

And I do agree very much with his comments on how the US Fed is trying to put the spin on the collapsing US Housing Market:

  • Spinning the housing downturn as a stock market positive

    The downturn in the US housing market is being spun as a stock market positive on the basis that it will force the Fed to begin a rate-cutting program and, as everyone knows, Fed rate cuts are bullish for the stock market. Well, it's often the case that what everyone knows is not worth knowing and that certainly applies here because Fed rate cuts are often NOT bullish for the stock market.

    When it comes to the setting of the Fed Funds Rate target the Fed will usually just follow the market in that some time after the market begins to lower short-term interest rates the Fed will start doing the same. However, lower short-term interest rates definitely wouldn't be a significant positive for a stock market priced in anticipation of strong earnings growth if the downward move in interest rates was a response to a sharp deterioration in the economic outlook.

    In any case, the whole idea that the Fed's next move will be to lower the official interest rate deserves to be seriously questioned because it is based on the assumption that inflation expectations will remain low. There are, however, conditions that have a reasonable chance of arising over the coming months that would invalidate this assumption. Before we mention what these conditions are it's important to understand the Fed's greatest fear.

    It is often said that the Fed fears deflation. This is true, but the Fed's fear of deflation can be likened to your editor's fear of swimming with Great White sharks. Your editor would be very fearful of jumping into the water if he suspected that a Great White was lurking below, but sharing a patch of water with a Great White is not something he spends any time worrying about because it is something he can easily avoid. It's the same story with the Fed and deflation. Deflation would be a nightmare for the Fed, but Ben Bernanke will never spend much time worrying about it because he knows he can easily avoid it.

    What the Fed regularly does have to worry about is an out-of-control surge in inflation expectations. The Fed can create money in unlimited quantities at practically zero cost, but today's money continues to have value because most people TRUST that it is going to do no worse than lose its purchasing power at the rate of a few percent per year. Or, to put it another way, the money is essentially worthless but as long as most people BELIEVE that the money will decline toward ultimate worthlessness at a slow pace it can continue to be a useful medium of exchange.

    The Fed and all other central banks would face a problem, though, if a critical mass of people began to anticipate a rapid acceleration along the road toward eventual worthlessness. If this happened then the Fed would be at risk of losing its ability to keep the world's greatest confidence game going, and it is this risk, not the risk of deflation, that has the potential to keep a central banker awake at night.

    We'll now return to our original discussion. There is a significant chance that additional weakness in the housing market WILL prompt the Fed to begin reducing the official short-term interest rate target within the next few months, BUT ONLY IF inflation expectations remain under control. On the other hand, if it looks like the gold price is about to breakout to new multi-year highs then cutting interest rates will probably be the last thing on the collective mind of the Fed, regardless of how weak the housing market happens to be.

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