Don’t fight the Fed – not this time?

There is an old market adage that one should not fight the Fed. However, this week, the markets did not follow this advice. As the result should have been widely expected, in particular after the TV interview of Fed chairman Bernanke a few days before the FOMC meeting, buying the rumors and selling the fact would also not describe correctly the reactions in financial and commodity markets.

The FOMC almost kept the statement unchanged from the one issued after the November 3 meeting. However, the US Treasuries sold off and the yield on the 10year note rose to 3.5%. But also gold pared its gains and corrected strongly following the release of the FOMC meeting. Only the downgrade of Ireland by 5 notches by Moody’s led to a recovery of gold at the end of the previous week. While we pointed out that a rise of US Treasury yields would be negative for gold as its opportunity costs increase, the arguments provided from market commentator for the moves in the markets are not convincing. In addition, the US dollar profited only marginally from higher US yields as the debt crisis weighed still on the euro.

 The bond market sold off because investors fear that inflation would increase. True, that is the target of QE2. However, the current core PCE inflation is too low and the target of the Fed seems to be close to 2%. And this is well knows since the Fed prepared the markets for the implementation of QE2. But some investors and traders expected the Fed would scale back the volume of QE2 after some recent developments.

While during the summer, economists, among them the famous Dr Doom Nouriel Rubini, predicted the US economy would slip into a double dip recession in H2 of this year, the recent economic activity data points to a slightly firmer economic growth. Despite the recent slight decline, the PMIs for the manufacturing and the service sector indicate a robust expansion. However, the growth of US GDP is still to slow to create enough new jobs that the unemployment would decline. In addition, the capacity utilization rate of the US economy at 75.2% is far below a normal utilization level. Therefore, there is no inflationary pressure in the pipeline and the US economy could expand at a higher rate without leading to inflation.

Another widespread misinterpretation is the compromise between US president Obama and the Republicans to extend the Bush tax cuts. This is not an additional fiscal stimulus, which would lead to an overheating of the US economy. It is just an extension of the status quo. Without prolonging the Bush tax cuts, the fiscal policy would have got less expansionary and would have been negative for US GDP growth. Thus, with the decision to exit from expansionary fiscal policy later the US administration just prevents that the still weak US GDP growth would be dampened further. The extension itself does not lead to additional aggregate demand but avoids a drop of aggregate demand. Thus, it has no inflationary implications at the current state of the US economy. It would only be negative if the US economy was overheating, but this is not the case.

As the US economy is far from achieving the Fed’s target of growing sufficiently to reduce unemployment and that core PCE inflation is in line with what the Fed considers as appropriate, the FOMC is far from looking forward to tight tighten monetary policy in 2011. The bond and money markets got too far ahead of the curve. US monetary policy would not be a supportive factor the US dollar as far as the eye could see. Thus, we still expect that the US dollar remains a supportive factor for the demand of precious and base metals also in 2011. However, this does not exclude temporary recoveries of the US dollar, especially in the case that the debt crisis in the eurozone would show no sign of improvement.

This was the last contribution to this blog in 2010. The next article will be published at the beginning of January 2011. We wish a Merry Christmas and a Happy New Year to all readers.