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Another bubble that breaks the world?
In 1931 a financial writer named Garet Garrett wrote the now classic book, “A Bubble That Broke the World.” Garrett’s contention was that the Great Crash of 1929 was made possible by the Federal Reserve’s monetary policy. Eighty years later another Fed-induced crisis is forming which, if allowed to continue, threatens to again break the back of the U.S. economy.
Before we get to that let’s take a look at some current trends. The dominant theme for stocks and commodities has been the continuation of the Fed’s QE2 program. QE2, which is the Fed’s way of increasing liquidity, has been a tremendous success for both stock and commodity investors and there’s no question the stock market likes the Fed’s quantitative easing program.
During the credit crisis the old Wall Street bromide, “Don’t fight the Fed,” was called into question. But in light of the market’s strong performance since the Fed commenced its Treasury buying program there can be no doubting that when the interim trend for stock prices is up, fighting the Fed isn’t a winning strategy.
QE2 hasn’t been without its problems, however. Commodity prices have risen disproportionately to the relatively low level of domestic demand. Demand alone doesn’t account for the big run-up in the oil price, for instance, but there is ample reason for believing QE2 is behind the run-up in oil above $100/barrel. The oil price spike, should it continue, threatens to undo the Fed’s work toward economic recovery over the last three years.
When Fed Chairman Bernanke first began the quantitative easing program after the credit crisis, his nominal concern was the below-normal level of inflation (read deflation). But at this point he faces the very real prospect of continuously increasing food and fuel prices, which in turn could imperil the economic recovery.
Nearly everyone can see this problem developing…everyone, that is, but Bernanke. When questioned about the possibility that QE2 could spark another commodities bubble, the Fed chairman responded that the currently low level of domestic demand would likely prevent this from happening. He emphasized that bringing down the high unemployment rate was the Fed’s primary concern. The cost of food and fuel is getting higher, however, and has already led to a dramatic increase in many categories of goods and services.
In the latest edition of his Real Estate Timing Letter [www.RealEstateTiming.com], Robert Campbell asks, “If we double-dip into recession, what can the Fed do?” He suggests: “If soaring oil prices do cause the U.S. economy to double-dip back into recession, the Federal Reserve Board could find itself between a rock and a hard place as to what to do to resuscitate the economy and re-stimulate a recovery.”
Campbell pointed out that in nine out of the last nine recessions since WWII the Fed was able to pave the way for economic recovery by dramatically lowering the fed funds rate to encourage lending. This time, Campbell continues, the Fed no longer has that option since the fed funds rate is already at zero. “Houston,” he writes, “we have a problem – a big problem.”
Many observers are asking what the Fed could do if the high oil price threatens to take the economy back into recession. Atlanta Fed President Dennis Lockhart has suggested that one solution would be a new round of asset purchases, or QE3.
“Of course,” writes Campbell, “many market watchers feel that one of the reasons that oil prices are going up is because of the massive injections of liquidity the Fed has forced into the system by way of Treasury purchases. This process is known as quantitative easing – or QE1 and QE2 – because they were the first and second round of such purchases. Since then, economic growth has picked up, but it seems likely that a lot (or maybe most) of these massive doses of liquidity have flowed into stocks, oil and commodities – which would explain some of the huge price increases that have occurred in the last 12 months.”
Campbell concludes that “if the Fed were to respond to rising oil prices by engaging in even more quantitative easing, it could backfire and cause oil prices to go even higher – and thus worsening an economic downturn.”
The recent surge in the crude oil price has raised the specter of $4.00/gallon gasoline. When the national gas price average topped $4.00/gallon in the summer of 2008 it broke the back of a consumer already weakened by the housing price collapse. The economy and financial market situation is arguably in better shape than it was three years ago but does anyone really believe the consumer is in a strong enough shape to absorb another spike in fuel prices?
As we pointed out in a previous commentary, in the last 40 years, year-over-year rises in oil prices of 80% or more have always been followed by recession. No matter which way Mr. Bernanke turns, it seems he’s confronted with some rather ugly scenarios. And another potentially “world breaking” oil price bubble should be the chief of his worries.
Gold is about to test an important and long held theory, namely that the yellow metal is a “crisis hedge.” The front cover of two of the leading mainstream magazines last week bore adequate testimony to the crisis at hand: the Japanese earthquake and its aftermath. The front cover of Businessweek said it succinctly: “Crisis in Japan.” As if to further underscore the widespread feeling of anxiety over the latest global problems, the cover of the latest issue of Newsweek magazine says it even better:
When we think of crisis in connection with gold, most people think in terms of financial crisis, such as a stock market crash or banking crisis. But what about natural disasters that afflict major regions of important countries? Are such episodes bullish for the gold price? One of the most recent natural disasters to afflict a country of major import was Hurricane Katrina back in 2005. Katrina was one of the five deadliest hurricanes in U.S. history and it devastated New Orleans and parts of the Gulf Coast, inflicting over $90 billion in damage. The hurricane was a financial setback for the federal government and it was followed by a correction in the stock market. It proved to be a turning point for the gold price, however.
Although the gold price, like other asset categories, was briefly sold off when Katrina hit in late August of 2005, it quickly recovered and went on to new highs. Unlike the stock market, gold was a beneficiary of post-Katrina crisis investors who were seeking a safe haven. It should again benefit from the latest crisis.
With the return of volatility in 2011, it’s important for traders to have a sound trading discipline. Classical trend line methods can be useful but they aren’t particularly suited for a fast-moving, dynamic market environment. This is especially true where turning points occur rapidly in a market that is subject to cyclical crosscurrents as has been true in the year to date. That’s where moving averages come in handy.
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Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment. He is also the author of numerous books, including “Stock Trading with Moving Averages.” For more information visit www.clifdroke.com