Why the Fed will have to hike Steve Saville 14 November, 2003 Extracted from commentary posted at www.speculative-investor.com on 13 November 2003: In the 22nd October Interim Update we explained why we think the Fed will have to hike official interest rates over the coming 12 months by more than the market is presently anticipating. Then, in the 29th October Interim Update, we predicted that the Fed would begin talking about the risks of rising inflation by the 28th January FOMC Meeting. We are now going to revisit this matter because it is so important and because we perceive a large mismatch between the consensus view and what is actually going to happen. Many of our readers would be familiar with John Mauldin and his free newsletter that gets sent out to literally millions of people each week. Mr Mauldin doesn't expect the Fed to raise interest rates at all over the coming year so his view could not be described as typical (the consensus view is that there will be a modest increase in rates). However, his reasons for not expecting any rate hikes from the Fed are representative of the wrong-headed thinking that appears to be dominating interest rate discussions. If you haven't already done so we suggest that you read Mr Mauldin's latest analysis for a 'take' on why the Fed won't hike next year. In summary, the argument is that a) the Fed wants to see sustainable employment growth before hiking rates, and b) the Fed is going to buy insurance for a growing economy in the form of lower rates until after the November 2004 elections. These arguments would be valid if the short-term interest rate set by the Fed controlled the long-term interest rates set by the market, that is, if keeping the Fed Funds Rate at a very low level guaranteed that long-term interest rates would remain low. In the real world, though, the opposite is true in that the Fed is typically dragged along, 'kicking and screaming', by the bond market. We've attempted to illustrate the lead-lag relationship between the bond market and the Fed on the below chart of the 30-year bond yield. Point A on the chart corresponds to the time when the trend for long-term interest rates turned higher in October of 1998 while point B corresponds to the time when the Fed began to hike short-term rates (June 1999). The difference between the two points -- 9 months -- represents the time it took the Fed to respond to the changing financial/economic environment. Point C on the chart corresponds to the time when the trend for long-term interest rates turned lower in January of 2000 while point D corresponds to the time when the Fed began to cut short-term rates (January 2001). The difference, in this case, was 12 months. Currently, 5 months have gone by since long-term interest rates turned higher (point E on the chart). If the Fed follows the bond market with the same 9-12 month lag that characterised the past two major monetary-policy shifts then the first rate-hike will happen between March and June of next year. We expect that the first official rate hike will occur by March 2004 and that the Fed will be FORCED to hike rates aggressively during the 6 month period leading up to the November 2004 presidential election. The reason they will be forced to hike rates is that once inflation expectations get out of hand -- something that has a good chance of happening next year due to the excessively easy monetary policies of the past year -- it becomes counter-productive NOT to do so. This is because long-term interest rates are pushed higher by rising inflation expectations and long-term interest rates have a much greater effect on the stock market, the real estate market and the economy than do short-term interest rates. As such, at some point in the inflation cycle it becomes necessary to increase official short-term interest rates in order to quell the inflation fears and bring down long-term interest rates. Further to the above, the argument that short-term interest rates will remain low because the Fed wants them to remain low makes no sense. The Fed will only have the option of keeping short-term interest rates low for as long as long-term interest rates remain near current low levels. And long-term interest rates will only remain near current low levels for as long as inflation expectations remain subdued. However, if we are right about what is going to happen to the gold price, to commodity prices in general and to the US$ over the next year then inflation expectations are absolutely NOT going to remain subdued. Funnily enough, whether or not the Fed ends up having the option of keeping short-term interest rates near current low levels for much longer will be determined, to a large extent, by the actions of the Chinese and Japanese monetary authorities. There are two reasons for this. First, the credit expansion that is raging away in China is causing that country's demand for commodities to ramp-up at a staggering pace. Unless the Chinese authorities are successful in slowing the credit expansion and the resultant credit-induced boom within the next few months, the CRB Index will burst above its 1996 peak and begin heading towards its 1980 peak at a rapid rate. It doesn't take much imagination to realise that this would put enormous downward pressure on bond prices (upward pressure on long-term interest rates) throughout the world. Second, long-term US interest rates would already be much higher if not for the huge purchases of US Treasury Bonds and Agency Securities made by the central banks of Japan and China over the past year, Steve Saville email: sas888_hk@yahoo.com Hong Kong 14 November, 2003 Regular financial market forecasts and analyses are provided at our web site: http://www.speculative-investor.com/new/index.html One-month free trial available. Copyright ©2002-2003 speculative-investor.com All Rights Reserved ______________ 321gold Inc ref: 05304