What Next for Fed?

Wednesday, the Federal Open Market Committee voted to hold its key Fed funds rate at 5.25 percent.

Contrary to most of the mainline media, we have long forecast the Fed holding its rate with a bias to the upside.

[Editor's Note: Discover how stealth inflation is about to impact the price of stocks, bonds, and metals and which are going to be the big winners and losers in 2007.]

It was not until mid to late December 2006 that Wall Street and its supporting media fell into line with our thinking.

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Since its high in early December 2006, the yield on the benchmark 10-year Treasury is up by some 50 basis points. People who ignored our advice to sell medium and long-term bonds will have lost potential profits.

In making its recent prior decisions, the Fed has cited its growing concern over Consumer Price Index (CPI) inflation. As our readers will know, we believe the CPI is a politically "cooked" book that seriously understates the true rate of inflation, which we term, stealth inflation.

In a recent interview with NewsMax, Lou Dobb's of CNN agreed that he has "no faith in the CPI numbers." In addition, legendary former Fed chairmen, including Paul Volker and Alan Greenspan, have expressed concern over rising inflation.

Recently, the European Central Bank (ECB), with its single mandate to control inflation, raised its key repo (repurchase agreement) rate by 0.25 percent to 3.25 percent, putting yet more downward pressure on the U.S. dollar as yield sensitive investors increasingly diversified out of dollars into euros. The euro now stands at $1.30 as of Jan. 31.

The Bank of England also recently raised its key base rate by 0.25 percent to 5.25 percent, on fears of increased inflation. Sterling now stands at $1.96 as of Jan. 31.

Unlike the ECB, the Fed has the difficult "dual mandate" of both controlling inflation and encouraging economic growth.

In recent months, this "dual mandate" has faced the Fed with a very sensitive and difficult decision, for the U.S. economy looked like it may stall, with third quarter growth down to 2 percent. Slumps in home construction and auto production caused the Fed yet further concern about U.S. economic growth.

The Fed now has a third major and so far hidden concern — defense of the U.S. dollar.

Last year's continued slide in the international value of the dollar has unnerved many major holders of Eurodollars (U.S. dollars held by non-U.S. residents).

[Editor's Note: Warren Buffett is betting billions the dollar will crash in 2007.]

Countries such as China (with some $700 billion of U.S. currency and dollar denominated securities), Japan, and major oil producing countries have seen a major loss of value in their U.S. dollar reserves. China and some OPEC countries have announced a program to diversify part of their U.S. dollar holdings into euro, putting downward pressure on the "greenback."

In addition, unfriendly governments such as those of Iran and Venezuela have announced that they will sell their oil only for euros, thereby eroding latent support for the dollar.

Until now, our American government has adopted a policy of "benign neglect," over the dollar's international exchange rate.

We note that a falling dollar has an inflationary influence, which is of concern to the Fed.

America's main creditor nations are no longer prepared to continue to hold a central bank reserve portfolio largely composed of U.S. dollars in free fall.

In particular, we believe the Chinese have expressed their concern in no uncertain terms. Indeed, we believe they are tempted to use the threat of a massive sell-off of their dollars (threatening not just the credibility of the U.S. dollar, but the stability of the U.S. Treasury debt market) to lend weight to their demands.

We feel the Chinese are now in the process of executing a major international power play to maintain "open" markets in America, while their own markets remain relatively "closed," enabling them to continue to export cheap products to America in return for a massive transfer of American consumer wealth and investment capital to China.

We understand that this troublesome situation was the main reason behind the many visits to China in 2006, by U.S. Treasury Secretary Paulson, unusually accompanied on the last trip by Fed Chairman Bernanke.

Wednesday, U.S. Treasury Secretary Paulson, in his testimony to Congress, expressed his "frustration" with China's policy. We feel that frustration is a massive diplomatic understatement.

In summary, we believe that our government has recently been made forcefully aware that its exchange rate policy of benign neglect (or official theft by depreciation) is no longer tenable. Other nations now "require" that America stand up and "defend" the credibility of its currency.

This places a major (international) pressure on the Fed, to raise its (domestic) rate.

We have believed this upward rate pressure has existed for some time, but has been hidden from public view.

Until now, we believe it was the fear of recession that has kept the Fed from raising rates at it two most recent meetings.

Wednesday, the Commerce Department announced that U.S. economic growth for the last quarter of 2006 was at a most unexpected rate of 3.5%.

According to Bloomberg, this was the strongest rate of increase since the first quarter 2006 and, following a 2% rate for the third quarter and close to the top end of the bracket (1.8 to 3.9%) of some 77 forecasters.

Most importantly, it may remove the fear of recession from the minds of the FOMC and allow the Fed to concentrate upon the other half of its mandate to control inflation.

It will also allow the Fed turn its attention to what we believe is its new task, which is to help restore international credibility to the U.S. dollar and ensure continued stability in the U.S. Treasury market.

[Editor's Note: Will Bernanke's Dollar Panic Happen?]

We believe therefore, that while the Fed has held rates for now, the probability of rate hikes in the future is now high.

In addition, we believe there will be a move towards quality. It follows therefore, that "risk" premiums will return, especially in high yield and emerging market debt instruments.

We repeat our advice that conservative investors should stay clear of medium and long-term bonds and concentrate increasingly upon both liquidity and credit risk.

For short-term bonds, our readers should concentrate upon high coupon bonds. These bonds tend to fall less fast in time of the rising interest rates that we foresee.

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