The first hint of higher interest rates in the States arrived after this week’s FOMC meeting.  Thomas Hoenig (President of the Kansas City Fed) emerged as the first interest rate hawk on the FOMC and voted against an unchanged monetary policy.  Hoenig “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Fed funds rate for an extended period was no longer warranted”.  In plain English Hoenig wants the Fed to signal to the markets that it is going to begin hiking interest rates at some stage in the not too distant future.

At the moment Hoenig is the only dissenter on the FOMC.  It will pay to keep a close eye on whether his view gathers support at future FOMC meetings.

The market’s reaction thus far to Wednesday’s announcement has been most evident in the US Dollar.  Its rally, which began after the 4 Dec 2009 Employment Report, has continued and the Dollar Index (DX) has now broken above its 200-dma.  The 50- and 200-week moving averages are the next resistance levels to be surmounted and they lie just above the current 79.59 level of the DX.  Hoenig hankering after US rate hikes will only serve to help the Dollar to extend its recent rally.  Commodities (as measured by the CRB index) have reacted badly, the US stockmarkets have remained under pressure (but they started falling two weeks ago) but the all-important US Treasury bond market has traded sideways despite Hoenig hinting at higher rates sooner rather than later.

However it is difficult to believe that the Fed is going to implement the first rate hike until the US economic recovery has gained significant traction which results in a very visible fall in the unemployment rate from its current 10%.  There is so much spare capacity in the States that the Fed can afford to let growth continue to build momentum without worrying about higher inflation resulting anytime soon.  Any premature rate hikes would be a serious policy error which would impact the economy & stockmarkets severely.

A more likely explanation for Hoenig’s action in voting against the others is that it allows the Fed to test the market’s reaction to a proposed change in the current policy stance of “low rates for yonks”.  If markets react badly over the next few weeks (particularly if the US bond market tanks) then we can expect all the other FOMC members to very publicly bang the drum that interest rates are not going up anytime soon.  The FOMC knows full well that it will eventually have to tell the markets that rates are not going to stay at “exceptionally low levels for an extended period” and this is a low risk way for it to prepare the markets for an eventual change in monetary policy.

I still think that the first US rate rise is out of view and over the horizon (and more likely to take place in 2011 than 2010) but will be paying close attention to future FOMC statements for clues as to when policy is likely to change.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).

The Dow made it as far as 9,918 in the rally after the FOMC statement was released on Wednesday 23 Sep 09 before turning around and selling off for the rest of the week.  Does it matter that this rally off the March lows hasn’t made it all the way to the magic round number of 10,000?

The bears keep pointing out that the market is on too high a p/e ratio for a new bull market to be truly underway and therefore a big correction must be just around the corner.  However see “Is the Bear Market Over?” for the reasons as to why the Dow is unlikely to take out the 6 March 6,470 low.

The bull’s case can be summed up in a beguilingly simple way:  The Fed and the BoE are determined to keep interest rates close to zero and carry on printing money until a sustainable economic recovery is underway.  As it is the stockmarket’s job to discount the future then it doesn’t matter what the shape of the economic recovery is going to be (V, W, U or the more exotic Square Root sign), it is more important that an economic recovery is on its way and therefore the market will keep on rallying in order to discount the coming recovery and will continue to frustrate those people who are looking for a big pullback so that they can buy into the market.

The problem the bears have is that anyone disagreeing with the bullish argument above is essentially saying that the central banks are going to fail in their mission to reflate the economy and help an economic recovery to take hold.  There is a very old saying in the markets which goes “Don’t Fight the Fed”.

The central banks have more money than individual stock market participants and thus far the Fed has promised to print $1.75 trillion (they are slowing down the rate of spending as the economy appears to be entering a gentle recovery but rest assured, they will print more money if the economy stumbles again in 2010).  The BoE is set to print £175 billion and they are not slowing down the printing presses as the Governor would prefer to print £200 billion and then see how the economy is getting along.

Possible events which could derail the current rally include a sharp sell-off in the Government bond markets, the monoline insurers being downgraded, problems emerging in German banks once the 27 Sep elections are safely out of the way, Spanish banks admitting they are in trouble with their loans to property buyers and developers (how are the Spanish workers going to generate enough money to service their mortgages when nearly 20% of them are unemployed?) or the US economy slipping back into recession next year now that the boost to demand created by their “Cash for Clunkers” program has expired and especially if the Bush tax cuts are reversed at the end of 2010.  However for now these potential problems are hiding over the horizon and, with interest rates close to zero, the stockmarkets may continue to frustrate the bears and just carry on squeezing higher, climbing the “Wall of Worry”.  We have already had the “Dash for Trash” and therefore the next part of the rally will have to be led by the big quality blue chips.

The Fed made it clear to the market with this week’s FOMC statement that speculation of a rise in the Fed Funds rate anytime soon is completely misplaced.  The Fed pointed out that with US GDP still contracting the economy has not yet even begun to work through the vast amount of slack in the system (capacity utilisation down near 65% and unemployment at 9.4%). It is this same spare capacity that means they are also not worried about the recent rise in energy & commodity prices feeding through into a sustained rise in inflation.

Even when US GDP starts to grow again (possibly later this year given that excess inventories now seem to have been worked off by manufacturers) it will take many quarters to chew through all the slack in the system (and the US economy has yet to contend with Obama raising taxes/allowing the Bush tax cuts to expire).  Therefore the FOMC “continues to anticipate that [the Fed Funds rate will stay at 0.25%] for an extended period”.

Those who think that the economy will bounce back strongly and that the Fed will soon be taking back some of its rate cuts should watch what the Fed does when it completes its $300 bln purchase of Treasuries in the autumn.  If the Fed announces it is going to spend additional money buying Treasuries then rate hikes will stay off the agenda.  Stock markets have bounced and bond yields have backed up as financial markets have regained their poise this year after the carnage inspired by Lehman’s bankruptcy last autumn.  Markets have gone from pricing in a depression to pricing in a prolonged recession and equities are currently consolidating after their sharp rally off the March 2009 lows and digesting the supply of fresh equity from corporates who are either getting their balance sheets back into shape or raising funds to take advantage of opportunities they see in the current environment (banks are not lending and credit spreads remain wide so equity is currently the default source of funding).  This is why the “green-shoot spotters” are out in force at the moment as the next move in the markets will be driven by perceptions of economic recovery or a slip back into a W-shaped recession.

For the foreseeable future the Fed continues to stimulate the economy by keeping rates close to zero and buying up Treasuries & mortgage-backed securities.  It will keep the pedal pressed firmly to the metal until the economy has grown sufficiently to have taken some of the slack out of the system.  Anyone expecting the Fed to hike rates the instant GDP starts to grow again is going to be disappointed (it is not going to repeat the 1997 Japanese mistake of raising taxes and snuffing out economic recovery the instant it has started)- a better guide to the timing of a rise in the Fed Funds rate will be given when the unemployment rate is at least two percentage points off its high and capacity utilisation is above 75% and the Fed has seen what impact any Obama tax increases have on the economy.