Sponsored Link:

Federal Reserve

The Smart Profits Report: Issue #469
Wednesday, October 31, 2007

The Federal Reserve: Will The Fed’s Latest Trick Bring A Treat For Investors?
By Martin Denholm
Managing Editor, Mt. Vernon Research

You scared yet? I bet the Federal Reserve bankers are.

It’s Halloween - and right on cue, there are some real gremlins prowling around Wall Street at the moment. Several scary scenarios for the bankers to ponder, as they prepare to make their latest monetary policy announcement this afternoon.

And the clamor for a cut has swelled so much that the bankers are actually worried about the high expectations.

In fact, the futures market has all-but guaranteed a rate cut. The Bloomberg Financial Markets’ Federal Funds Implied Probability Calculator pegs the chance of a 0.25% rate cut at 70% and a 0.5% cut at 22%. And if the market doesn’t get what it wants, the scene may resemble one where vampires have gone on the rampage - awash with red and lots of blood spilled.

Federal Reserve At The Mercy Of A Fickle Market

When the Federal Reserve slashed interest rates by 0.5% on September 18, it shocked the majority of economists, analysts and investors who had expected a more benign 0.25% cut.

It’s also pretty safe to say that once the bankers wielded the axe, they probably didn’t think the market would be so demanding next time around. But the market is fickle and spoiled. Let’s wrestle with the bulls and bears…

The one morsel of good news is that third-quarter GDP growth rolled in at a 3.9% annualized rate. It was the best since Q1 2006 and pretty impressive, considering the credit mess that resulted from the subprime collapse.

But now, the economy is contending with more upheaval, which makes the rumored revision to fourth-quarter growth rather bemusing.

Oil Prices Top $93 A Barrel

Blink and you might miss it. Oil prices recently topped $93 a barrel.

The market has cried wolf over oil prices before. As prices climbed to $50, then $60, then $70, then $80, each new mark triggered a fresh bout of, “OK, folks… this is it. Recession time. And this time, it’s serious. No, really.”

Have we seen a recession? Nope. But on October 26, one of Merrill Lynch’s leading bears, David Rosenberg, flatly stated, “We think a miracle is needed to avoid recession.”

With oil prices up one-third since mid-August, the market has $100 firmly in its sights. But Abdullah al-Attiyah, Oil Minister for OPEC nation Qatar, says this isn’t because of supply shortages, but rather geopolitical issues and rampant speculation that it is powerless to solve, no matter how much people want a hike in output.

Gasoline prices are heading north, too. The price per gallon is already over $3 in many areas of America. And Americans aren’t just going to get squeezed at the pump…

Heating Costs Set To Spike

According to the Energy Information Administration, home heating costs are set to spike, too…

  • Oil heating costs will jump 22% this winter. That’s an extra $319.
  • Natural gas users don’t escape either, with costs set to rise by 10% ($78).
  • Electricity costs will rise 4% ($32). Almost one-third of U.S. homes use electricity for heat.
  • Propane costs will climb 16% ($221).

Averaging out the costs for all the types of fuels, Americans will pay $977 to heat their homes this winter - 10% more than the $889 last season.

And even if the Federal Reserve provides some monetary relief again, I doubt whether it will be enough to offset other high costs. And that doesn’t bode well for one sector, in particular…

‘Tis The Season For Retail Struggles

Of the 12 months in the year, imagine if you depended on just two of them to generate half of your annual revenues. That’s the scenario that faces America’s retailers every year. But already, the National Retail Federation has projected a murky outlook, with sales growth of 4%, compared with last year’s 4.6% rise.

The group bases the projection on “too little, too late” from the Federal Reserve. Even after its September rate cut, same-store retail sales (stores open at least a year) edged up just 1.4%. And October wasn’t much better, with 2.4% sales growth expected, well below the 3% rise in October 2006. The benefits of rate cuts take time to filter to consumers, and many believe the Fed’s action won’t help holiday retail sales.

That’s bad news for a U.S. that depends on consumer spending to fuel two-thirds of its growth. And the real estate market certainly isn’t helping consumers much either…

Real Estate & Housing Hell

Rather than waffle on about the current real estate market, I’ll let the statistics tell the story…

  • Existing home sales slumped 10% from August to September, according to the National Association of Realtors.
  • New home sales were revised down in June, July and August. And although September sales rose, it didn’t factor in order cancellations. This is a crucial element, given that D.R. Horton reported that half its orders were cancelled between July and September.
  • Homebuilders slashed their housing investment by an annualized 20% during the third quarter.
  • Almost 18 million homes sat empty during the third quarter, according to the Census Bureau. That’s the largest amount ever. And only two million of them are for sale.
  • The Federal Reserve says overall house prices have declined between 2% and 5% over the past year. And the CEOs of Countrywide and KB Home both believe that the worst is yet to come.

Then there’s the dollar…

The U.S. Dollar Way Down, Gold Way Up

As the Federal Reserve prepares to cut rates again, the world’s currencies have taken it as their cue to rise further against the U.S. dollar.

  • Just yesterday, the British pound set a 26-year high of $2.06 and has $2.10 in its sights with U.K. inflation close to the Bank of England’s 2% target level and the likelihood of “no change” when the bankers meet again on November 8.
  • The euro also hit another record high of $1.44 on Monday, with the storming Canadian and Australian dollars also trading at two-decade highs.
  • And with the dollar sinking, gold prices haven’t wasted any time in racing to $794.40 an ounce this week - the highest level since January 1980.

A continuation of high oil prices, the flagging dollar, and an interest rate cut would clearly bode well for the gold market. But it’s a frothy market right now - and the smart money is pulling back. Hedge funds are “long” around 46% of the market and reduced their long positions by 7.7% last week, according to the U.S. Commodity Futures Trading Commission. Meanwhile, the “commercials” are “short” on almost two-thirds of the market.

The Federal Reserve’s Best Option… And Yours, Too

The Federal Reserve has three viable options - but only one is best:

  • A 0.5% Cut: This would be too much and could artificially inflate the market while hurting the dollar. It wouldn’t take long before the rally ended and investors paid more attention to the damage done to the dollar instead. While helping exporters, a weaker dollar would further raise import costs and could send inflation higher, as well as reducing foreign investment in the U.S.
  • No Change: With the ongoing housing market woes, as well as high oil prices hitting consumers’ wallets at the gas pump and energy bills, and retailers braced for a struggle, the Federal Reserve is loath to ignore these factors. However, the bankers are also mindful that a cut might trigger higher inflation.
  • A 0.25% Cut: While certainly not the answer to all the problems, this is the middle ground and the best option. It would provide relief and send a message that the Fed is active without being overly aggressive or too weak.
  • Bottom line: The dollar is extremely oversold, but the chance of a recovery is very slim - especially as the Fed hacks away at interest rates and the “twin deficits” remain a key factor. Relative to what they can get from other countries, few investors are going to want U.S. dollars, since the interest rate and return is much lower.

On the bright side, a lower dollar is excellent for exports. For example, third-quarter U.S. exports jumped by an annualized 16.2% - the biggest rise since Q4 2003. Make sure you own U.S. companies with a strong international presence to give you diversity from the dollar. Industries like defense, technology and biotech should perform well.

Or for a more direct approach, invest in foreign countries with higher growth rates and stronger currencies (China and India are two examples). You can do so either through individual firms that trade in the U.S., or through foreign ETFs.

Best regards,

Martin Denholm

Sign Up for The Smart Profits e-Report!

Today’s Smart Profits Action Center

  • Another way to diversify out of the U.S. dollar and into stronger foreign currencies is through EverBank. The firm offers investors a great way to do so through one of its 15 World Currency CDs. For example, the annual interest rate on the Australian Dollar CD is 5.13%. For the British Pound CD, you get 4.5% (with further strength against the dollar expected as the Bank of England leaves interest rates unchanged next week). In addition to benefiting from further appreciation of foreign currencies against the U.S. dollar, the CDs have flexible maturity terms, has no monthly account fees, and is FDIC insured. For details, please click this link.
    (Disclaimer: The publisher of the Smart Profits Report has a marketing relationship with EverBank, but that’s because we believe it has the most competitive products on offer).
  • Get interactive! If you’ve got any views on the Federal Reserve, the dollar, oil prices… or any other economic/investment topics that you’d like to share with us and your fellow readers, feel free to drop us a line - we’d love to hear from you. While we may not be able to respond to all e-mails, we’re always interested to get our readers’ opinions on issues like this and may feature your thoughts in a future column. You can e-mail us here: editor@mtvernonresearch.com

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2007 

Comments

Comments are closed.