After the Dow Jones Industrial Average came within 80 points of its all-time high, stocks simply fell apart. The decline occurred immediately after the May 10th FOMC (Federal Open Market Committee) meeting when the Fed said that there weren't enough solid signs that inflation was under control for it to stop raising interest rates.
Bubbles to Pop
I have maintained that in order for the Fed to stop raising rates, two bubbles must pop: Housing and Commodities. There is now overwhelming evidence that housing has turned down. All economic indicators - Housing starts, completions, mortgage activity, sales of new and existing homes - you name it - have topped out. And realtors will tell you that house prices, particularly those in the hot areas on the East and West coasts, have turned downward. Prices of condominiums in my home town of Philadelphia are down anywhere from 5% to 10% from last year.
So why didn't the Fed pause raising rates? Commodities. In early May, just before the Fed meeting, gold soared to a 26-year high and oil prices topped $75 a barrel. Furthermore, industrial metal prices, such as for copper, aluminum, nickel, and zinc were setting all-time highs. If the Fed wanted to maintain its anti inflationary credentials, which are particularly important with a new chairman, it could not promise that inflation is under control.
Right after the disappointing Fed statement, the stock market declined. On Thursday, the day after the meeting, the Dow Industrials dived 142 points and then fell 120 more points on Friday. The following Wednesday was particularly brutal, with the Dow falling 214 points before stabilizing. The reason for the decline was fear that the Fed would have to jack up interest rates significantly. Bond yields immediately rose, anticipating further Fed action.
Two years ago, when short term rates were 1%, buying stocks was an easy decision. With dividend yields of 2%, investors got paid more for holding stocks than by holding cash. But with money rates now at 5% and headed upward, stocks are a more difficult choice; their prices have to rise to make up for the difference in yields.
Higher Rates Beginning to Slow Economy
After the stock decline and upward movement in bond yields, we are seeing tentative signs that the commodity bubble may, like the housing market, be cooling down. As of this writing, gold is down to $652 an ounce, nearly $80 below its high of $730 reached on May 12. Other metals are also down and, more importantly, oil is (so far) staying below its $75.35 a barrel high.
I wish I could say with certainly that the commodity bubble has burst. But I cannot. Previous price declines have been met by even higher prices later on. If the commodity market surges again, the Fed will be forced to raise rates. If this happens, I think that a 50 basis point (one-half percentage point) increase will do the trick and convince the speculators that the Fed is serious and can squash any bubble it wants to.
But hopefully it won't come to that. The economy is already cooling. Housing activity is headed downward and the higher gasoline prices and interest rates will put a dent in consumer spending.
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