History Points to Higher Rates!

Puru Saxena
17 Jan, 2006

The New Year has started with a loud bang with global equity markets charging ahead. Investors worldwide seem to be celebrating the Fed's announcement, which stated that its policy outlook "was becoming considerably less certain", the number of additional rate hikes to control inflation "probably would not be large" and the future rate decisions "would depend on the incoming data".

The above statement was perceived as a rather soft message and investors now believe that the interest-rate hikes are about to end. On this expectation, the markets reacted sharply and equities as well as bonds rallied, the US dollar sunk and precious metals rebounded after the recent sell-off.

In my opinion, the markets over-reacted to this news as I feel that the Fed funds rate is going to rise significantly in the future. Perhaps, the Fed will pause momentarily after the Fed funds rate is pulled up somewhat more but the overall trend for interest-rates is now up. Take a look at the chart presented here, which shows the direction of the Fed funds rate since 1955. The Fed funds rate went up from 1955 to 1981. Thereafter, the cost of money (interest-rate) declined for the next 23 years. I believe this cycle reversed when the Fed funds rate bottomed at 1% and we are now in the early stages of a major uptrend, which will probably last for years.

Over the past year, the money supply in the US has grown by 7.3%. In other words, inflation in the US is running above 7%, which is still significantly higher than the current Fed funds rate of 4.25%! Quite simply, even today, the Fed is literally giving money away. In my view, the Fed has no choice but to continue raising its rate otherwise the massive ongoing inflation will surface through even higher commodity prices and the public will smell the rat. If the Fed doesn't continue to hike, the price of gold and oil could go up to the point where people lose faith in the modern-day monetary system - not what the Fed wants!

It is my observation that when commodity prices went crazy in the 1970's, the Fed increased its interest-rate to almost 20% in 1981. If it hadn't increased the Fed funds rate dramatically, the American currency would have collapsed as people continued to exchange their dollars for tangibles.

Today, the majority of analysts feel that the Fed will not raise rates any further because if it does, then the US stock and property markets will get badly hurt. However, these analysts seem to forget that during the 1970's, the US economy was in a mess, Britain had to be bailed out by the International Monetary Fund (IMF) and America's stock market was in shambles. Yet, the Fed continued with its rate hiking programme without caring too much about asset-values! Why? Remember, the Fed can tolerate a recession or a bear-market but it can't survive if people realise that the US dollar is basically a junk currency, which will only become worth less over time due to inflation. So, the Fed has to ensure that the US dollar loses its purchasing power rather gradually. If this process speeds up and becomes evident, the Fed must intervene to halt the US dollar's destruction (temporarily) by raising its interest-rate.

In the current environment, as the energy shortages become more evident, consumer price levels and commodities are going to rise significantly. Therefore, in order to maintain the public's confidence in the US dollar, the Fed will continue with its monetary tightening.

If my assessment is correct and interest-rates continue to rise, the equity and real-estate markets will come under pressure. According to the brilliant Gavekal Research, the tightening is already taking effect and the monetary base has not been expanding as rapidly in the US for a while now.

The global economy also faces some other challenges, which may disappoint equity investors after the first quarter of this year. After a substantial rise, the American housing market is showing signs of an imminent slowdown, which may hurt consumption in the world's largest economy. Americans have continued to spend by borrowing against their rising home prices. US consumption accounts for roughly 70% of GDP and if housing starts to deflate, its economy may come under strain. History has shown that the emerging economies have always suffered badly whenever with the US economy has softened. Therefore, caution is warranted if you have invested in the developing markets.

Recently, China announced that it plans to diversify its foreign exchange reserves band will reduced its exposure to the US dollar. China's reserves are close to US$800 billion and any major shift may cause the US dollar to decline resulting in turbulence in the capital markets.

Finally, crude oil prices may really surprise most people over the coming months. My research has convinced me that our world faces an energy crunch due to rising global demand and tight supplies. Several oil provinces in the world are now past their peaks and the global output may decline in the face of rising demand especially from the emerging economies of India and China. The previous bull-market in energy took place in the 1970's and caused a severe recession in the US. Moreover, Britain also had to be rescued by the International Monetary Fund during this period. So, history has shown that the global economy did not react too well when oil prices really exploded higher. Accordingly, the price of energy is another factor, which investors must watch closely.

In summary, I expect some more upside in the equity markets over the coming weeks. However, I am of the opinion that once a top is formed, the global stock-markets may embark on a very overdue and lengthy correction. Therefore, investors are advised to book their profits and fresh buying should only be done after a major shakeout. On the other hand, the commodities bull-market is gathering steam and investors must take a meaningful position in this sector without further delay.

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Puru Saxena
Saxena Archives
email: puru@purusaxena.com
website: www.purusaxena.com

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription from www.purusaxena.com.

Puru Saxena is the founder of Puru Saxena Wealth Management, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

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