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The Fed nears its day of reckoning

Speculation is heating up that the Federal Reserve could move sooner rather than later to start hiking interest rates
Speculation is heating up that the Federal Re... 01:09

It's no secret that this bull market has been running on fuel pumped by the Federal Reserve. With the central bank engineering the longest period of low interest rates in human history, bond market spreads have collapsed. And as a result, the stock market has been surging, thanks to corporate borrowing to fund share repurchases.

No wonder investors have been hair-trigger sensitive to anything related to the Fed. When it's been actively buying long-term bonds, under the guise of multiple iterations of its quantitative easing programs, stocks have done well. When it hasn't, such as in late 2011, stocks have suffered. Every word of every Fed statement and policymaker comment is dissected, reassembled and dissected again.

But now, investors are growing nervous as the day fast approaches when the Fed is forced to normalize its policy stance -- and actually start raising interest rates again.


In the minutes of the Fed's latest meeting, released on Wednesday, the policymakers conveyed that the current bond-buying program is on track to end in October. Moreover, they discussed whether investors have become too complacent about both risks in their portfolios and the continuation of near-zero percent interest rates.

A combination of a tightening job market (with an unemployment rate of 6.1 percent just three-tenths away from estimates of full employment) and higher inflation (consumer price inflation is growing at a 2.1 percent annual rate and poised for more) sets the stage for the Fed to remove the drip line of stimulus from the financial system.

The Fed, by nature a political institution, has resisted making any changes for as long as possible. The evidence suggests (using a simple Taylor Rule analysis) it has already fallen behind the curve and risks holding interest rates too low for too long, creating the threat of new asset price bubbles just as the job market returns to normal from the aftermath of the Fed-fueled housing bubble.

Moreover, the folks at the Bank for International Settlements, the central bank of central banks in Basel, Switzerland, recently warned in their annual report that the Fed and other central banks were increasing the risk of financial turmoil later by resisting the need to shock the markets out of the complacency that has resulted from years of cheap-money dependency.

But now, to maintain its credibility, the Fed is being forced to acknowledge that the situation has shifted.

Should inflation continue to rise and the unemployment rate continue to fall, as is widely expected, Fed Chairman Janet Yellen will have little choice but to admit that conditions are changing when she speaks at upcoming events, including an appearance in front of Congress next Tuesday, the release of the next Fed policy announcement July 30 and the annual Jackson Hole economic symposium in August.

Based on Wednesday's trading action, investors aren't too worried. After an initial knee-jerk reaction lower, the rise in stock prices suggests people believe the Fed will continue dragging its heels on raising interest rates and tightening its monetary policy until inflation gets much worse. You can see this in the way the U.S. dollar was slammed lower while precious metals and related mining stocks enjoyed another surge of buying interest.

And there's reason to believe that even if the Fed does pull the trigger on higher rates sometime next year it may not be as catastrophic as feared: According to the team at Capital Economics, since 1970 the stock market has risen, on average, more than 11 percent in the 21 months following the start of a Fed rate hiking campaign.

The caveat is that this has been no normal interest rate cycle, so the reaction this time could be different. And of course, the dot-com bubble went the other way, with the market dropping 15.5 percent in the wake of the rate hike of June 1999.


For now, I continue to recommend investors maintain a focus on precious metals as an inflation protection strategy. Examples include the leveraged ProShares Ultra Silver (AGQ) which is up more than 24 percent since I added it to my Edge Letter Sample Portfolio back on June 5. For individual stocks, candidates include NovaGold (NG), which is up 22.6 percent since being added on June 5.

Disclosure: Anthony has recommended AGQ and NG to his clients.

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