Fedwatch: Bearish for Blue Chips
Jude Wanniski and David Gitlitz
August 8, 1997


From its morning peak yesterday at 8300, the Dow Jones Industrials dropped 122 points during the course of the day. Most of it came on comments from Kansas City Federal Reserve president Thomas Hoenig, who said that he still is worried about inflation because of tightness in the labor market. That’s all it took for the long bond to sell off more than a half point, following the better-than-expected 30-year bond auction earlier in the day, with the average yield at 6.45%. This follows last Friday’s two-point blow-out in bonds following a bit of good news from the survey of purchasing managers and from new car sales. That bond sell-off sent the Dow down a hundred points before a late-afternoon rally brought it back. NASDAQ also sold off with bonds on both occasions, but not as much as the blue chips. Next week’s fresh price data -- producer prices on Wednesday, consumer prices on Thursday -- should ease market anxiety that the risks are definitely not on the side of inflation. This would at least put on hold speculation about the possibility of a Fed tightening. 

That’s really not enough. The Hoenig comments are especially troubling because the Fed should really be worrying about the accumulating consequences of deflation. The dollar is about 20% stronger in gold terms than it was nine months ago, its trade-weighted value according to the Fed’s own index is up about 17%, and producer prices have declined for six consecutive months. Monetary deflation is certainly not the monster it was in 1981-82, when gold fell from $625 to $300 in 18 months and other commodity prices followed in train. But as long as gold remains around $320, below its optimum level of $350 by our lights, it is exerting the same kind of pain to dollar debtors at the margin. The 1981-82 deflation caused horrific bankruptcies, including Penn Square and Continental Illinois, as the collateral underpinning bank loans collapsed in price. We have alerted the Fed and Treasury this week of our belief that the collapse of Thailand’s financial markets were in no small part due to the dollar’s deflation since November -- which brought debtors in its currency, the baht, to ruin. 

Our financial markets at least have the benefit of the tax cuts in the budget bill. As small as the cut in capital gains tax and relief on estate taxation were, these tiny steps did strengthen the equity side of the national balance sheet. New enterprise that depends on equity -- because there is not yet an asset base to collateralize -- will continue to gain strength as the 20% rate is locked in, even with the evil 18-month holding period that will be Treasury Secretary Bob Rubin’s legacy. It is the blue chips, especially the big bank stocks that were creamed yesterday, which are now facing the continuing problems we have at the Federal Reserve. The only way the Fed could end the small but significant monetary deflation which is represented by $320 gold is by monetary ease. This would supply the liquidity demanded by an economy trying to expand. But nobody at the Fed or at the Treasury or in Congress is talking about monetary ease -- because the news on Wall Street and on the unemployment front is so rosy. 

With this being the case, the only other way to end the monetary deflation and get gold back to $350 (and it may not stop there), is to wait for the news to get bad enough. Those at the Fed who will only vote to ease on bad news -- like Hoenig and Fed Governor Laurence Meyer-- will never be willing to supply liquidity to prevent deflationary damage. As long as the Greenspan Fed remains hung up on the inflation/unemployment tradeoff of the Phillips Curve, this alone will serve as a drag on the stock market and prevent the DJIA from getting far above 8000, with more downside risk than we would like to see. There now are not many positive policy changes ahead that the market might anticipate. Some Republican leaders are talking about coming back next year to improve on their tax cuts. The alternative minimum tax (AMT) has to be fixed or low-income workers will soon be paying it. And revenues will continue to surpass the purposely low-ball projections of the OMB and Congressional Budget Office. This will put pressure on the GOP Congress to improve on its tax cuts. But there will election-year pressures that will militate toward spending any surpluses rather than reducing taxation.

For now, though, the Fed appears unlikely to hasten the bad news with another near-term policy tightening. This may give bonds a bit of room for gain. Certainly, the Beige Book released Wednesday in advance of the August 19 FOMC meeting would be unlikely to cause any alarm among the panel members. “Economic activity generally expanded at a moderate rate,” said the survey conducted for this meeting by the Richmond Fed bank. Although “labor markets tightened further,” the bank found “wage pressures remained generally subdued.” Prices overall were “stable,” the book said, reporting that prices for gasoline, crude oil, wheat, cattle and groceries were falling in several districts, while lumber, hay and hog prices were reported rising in others. At this point, then, the risk of a Fed rate hike is probably still some months off, a fact reflected in the interest rate futures markets, where the spreads remain narrow through September. Further out, the chances of a tightening rise sharply, with the three-month December Euro-futures now carrying an implied yield some 20 basis points higher than the September contract, up from nine basis points prior to last Friday’s rout.

For us, the report that “labor markets tightened further” is good news in an economy that shows no signs of monetary inflation. The unemployment rate may be its lowest in 23 years, but as Rep. Jesse Jackson, Jr. [D-IL], pointed out to Greenspan last month at the House Banking hearings, there remain 35 million Americans who say they would work if they could find jobs. They are not counted as unemployed because they have stopped looking for work. With real after-tax wages finally beginning to rise after several years in decline, and teenage black employment rising sharply as well, that potential pool will continue to relieve the kind of labor shortages that ignite talk of “overheating.” We’re also drawing on Canada’s labor pool, which has nothing to do, given the generally poor economic policies in Ottawa. 

For the Phillips Curvers at the Fed, the strike at UPS is exactly the kind of thing that worries them about “labor markets tightened further.” The Teamsters would not be striking if labor markets were easing. The union leaders see the potential of picking up members by pressing for a bigger share of productivity gains as the unemployment rate falls and the quality of earnings rises among the nation’s biggest corporations. That’s what unions do. The problem is that unions often press their demands before the corporations are sure the earnings will be sustained. If UPS gives too much and the Fed shuts off the economy with higher interest rates -- fighting a deflation with more deflation -- UPS is left holding the bag. 

There is a lot to worry about on the horizon, and we worry about all of it, well aware that the forces of darkness never take vacations and do their best work when everyone is celebrating. Our doubts about the long-term nature of the bull market remain small, though. We might just have to tread water for awhile.