THE FED DISCOVERS DEFLATION
FED FINALLY WORRIED ABOUT DEFLATION... They didn't actually use the dreaded "d" word (deflation). But the Fed has finally started to worry about "an unwelcome substantial fall in inflation". With the Fed's favorite inflation gauge hovering around a 40-year low at 1%, any further weakness could easily push it into negative territory. In other words, deflation. Those of you who have read our comments over the past couple of years know that we've been talking about "deflation" for a long time. We have stated on several occasions that deflation accounts for one of the major changes in intermarket relationships -- bonds and stocks.
BONDS RISE WHILE STOCKS FALL... Historically, bond and stocks prices have usually trended in the same direction. During a deflation, however, they "decouple". In other words, they trend in opposite directions. Bond prices rise and stocks fall. In that environment, falling interest rates don't help stocks. That explains why 12 Fed easings since the start of 2001 haven't helped stocks or the economy. Throughout the three year bear market in stocks, economists (and the Fed) have brushed off the threat of deflation. Incredibly, now they're starting to get worried. There's talk the Fed is going to lower rates again. Once rates get to zero, what are they going to do then? One of the things they have been doing is letting the dollar fall. That's being done in hopes of actually creating a little inflation.
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DOLLAR FALLS TO FOUR YEAR LOW WHICH IS GOOD FOR GOLD... One of the side-effects of having interest rates near zero is that it weakens the dollar. That explains why the dollar fell to another four-year low yesterday. As the dollar falls, however, that makes U.S. assets less attractive to foreigners. That's not good for U.S. bond and stock markets. One of the few markets that benefits from a falling dollar is gold (and gold stocks).
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INTEREST RATES ARE FALLING... Bond yields are falling again. That's a bad sign since it shows that the bond market is expecting more economic weakness or deflation -- or both. Since bond yields have been positively correlated to stocks throughout the bear market, we take this week's drop in bond yields as a potential negative sign for stocks.
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STOCKS REACH RESISTANCE... Many of the major stock indexes are getting near the tops of trading ranges that have been in effect since last summer. In addition, they're getting overbought. This week's drop in the dollar and bond yields could be enough to keep the stock averages from breaking out of their ranges. That would suggest that the market is about due for some profit-taking.
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