Higher can the Fed Raise Rates without Tipping the U.S. Economy into a Recession

THE DOLLAR

The Fed’s recent campaign to raise interest rates has certainty been supportive of the dollar. But one has to ask at this late stage: How much higher can the Fed raise rates without tipping the U.S. economy into a recession and can our economy handle a recession at this point in our history?

We are a nation of debtors who have literally piled up debt in the last few decades, particularly within the last 16 years. You will recall that I address our astronomical debt in almost every newsletter. Again, I remind you that, excluding unfunded liabilities, our debt currently exceeds $40 trillion (corporate, personal, and government), and 65% of that debt has been created since 1990. This has put tremendous pressure on the dollar.

The dollar’s most recent peak occurred in February 2002, when it hit 120.5 on the dollar index (an index tied to several major currencies). Over the next two years, the dollar plummeted. By December 30, 2004, it had dropped to 80.59. The dollar rose off of that bottom; and on December 16, 2005, the dollar index was 92.39. As of this writing, however, the dollar has declined to the mid-80s. Although interest rate increases by the Fed stopped the steep rate of decline, the dollar’s rebound has been weak, at best. No currency has ever stood the test of time, and no country has ever put as much pressure on its currency as the United States has placed on the dollar!

Personally, at this Juncture, I don’t see how the Fed will be able to raise rates much higher. In their last tightening cycle, which ended on May 16, 2000, the Fed Funds Rate only reached 6.5% before it tipped the economy into a recession in the ensuing year. This, of course, sent the stock market plummeting. Today we have exceedingly more debt. As a result, I believe we are far more vulnerable if we should enter into a recession.

If the Fed goes too far, it will kill the housing market; and the stock market and the U.S. will lapse into a recession or something worse. I believe that the Fcd has reached the end of its rope and that the interest rate hikes will come to an end soon, If they haven’t already. In fact, I believe it won’t be long before the Fed reverses its actions and begins to lower rates. This is, after all, their “MO” -- lower rates to fight off a receding economy and raise rates until the economy lapses into a recession.

History says that, somewhere in the future (and not too distant), rates will be dropping, and the Fed will be increasing the money supply. That will, once again, apply downward pressure on the dollar. That downward pressure ultimately will be good for gold.

In their July 2006 Aden Forecast, the Adens wrote, “Top ranking Chinese bank officials are starting to speak out. Interestingly, a deputy governor of the People’s Bank recently said that countries around the world should gradually rely less on the dollar for trade and foreign exchange. A Chinese central bank advisor also made the formal recommendation that China should start diversifying its nearly $1 trillion in foreign currency reserves into gold and oil to hedge against a drop in the dollar.” Of course, this is an attack on the dollar’s status as the World’s Reserve Currency. I believe we can expect more of the same in the months and years ahead: fewer and fewer foreigners willing to produce goods by the sweat of their brow in exchange for paper dollars that are created out of thin air.

The Adens also point out that China holds about 70% of its reserves in dollars and only 1% in gold and that even a small portion of those reserves being placed into gold would be very bullish for gold! The Adens went on to say, “The point is, gold is in a mega bull market. That’s the big picture and it’s happening to coincide with this mega world power shift.”

REAL ESTATE

Last fall I wrote that the real estate market was potentially topping out. At that time I was warning my family and friends not to overextend their investments in real estate as well. From my perspective, it had the appearance of a market that had seen its best days. Yes, they don’t make land anymore, but the problem with real estate is that most people leverage it to the hilt and when the market turns down and prices begin to fall, real estate becomes illiquid.

The real estate market had been in a bull-market cycle since 1995. It had become the backbone of the American economy, supporting everything from retail to the stock market. It is for this reason I believe the Fed cannot allow the real estate market to collapse. The result would be a deep recession. Yet, at this point in time, I wouldn’t want to bet on that by investing my money in real estate.

This has been the greatest real estate market in the history of our nation. Almost everyone has invested in real estate, how many of your friends are in the precious metals market today--probably none? Historically, that’s the time to buy.

STOCK MARKET

The stock market’s long climb off of its October 2002 bottom has looked good, but has it really been good? And is it destined to climb ever higher, or is the best behind us now?

As of late, the market seems to be tiring. I don’t know how long it will be before the bear market rally that began in October 2002 breaths its last breath and heads down in earnest, but I think we are getting closer and closer to the end. It is interesting to note that on Friday, March 10, 2006, with the Dow at 11,076, Lowry’s Reports wrote that although the Dow was down just 1.5% from its 2000 high, the 30 stocks that make up the Dow were down an average of 22.1%. This indicates that only a few select stocks have carried the stock market higher. While the stock market has painted a pretty picture, the majority of stocks have not done so well. This might not be of great concern if the stock market were in the beginning of a bull market and stocks were undervalued. However, I believe, as do the analysts I follow, that the stock market is overvalued. I believe the stock market is still in a secular (long-term) bear market and that somewhere ahead we will see another downturn. This downturn may be worse than the tumble we experienced when the tech bubble began to burst in the spring of 2002. It was said that more money was lost after the rally that followed the 1929 crash than was lost during the crash itself.

The following are comments from Richard Russell’s Dow Theory Letters for June 13, 2006-

“Subscribers know that I adhere to the thesis that there is only one dependable market cycle, and that is the never-ending stock market cycle in which stocks go to overvaluation (a bull market) and then to undervaluation (bear market), and then up to overvaluation again (new bull market) and on and on. The KEY to these cycles has always been, and always will be, VALUATIONS.”

“Here’s one thought that’s never left my mind and this is it - at the lows of 2002, stocks never got anywhere near undervaluation. In other words, at the 2002 lows there was nothing that even hinted of a classic “great valuation” bear market bottom. In my opinion, the bear market that started in 2000 never ended. For that reason, I believe the end of the bear market lies somewhere ahead.”

“If I’m correct that means that this year, next year, maybe two or three years from now we are going to experience a classic bear market bottom in which stocks have declined to the area where they represent great values. Historically, bear markets end amid an area of great value - at such times the Dow sells at 7-8 times earnings while the yield of the Dow is at 6%, 7% or even higher.”

According to Decisionpoint.com, if the yield on the S&P 500 were to rise to the levels normally seen at bear market bottoms, say to 6%, the S&P 500 would have to decline to 375 points. As of this writing, that is a decline of more than 70%. With a 6% yield on the Dow, it would have to drop to 4,418. 1 think most Americans would be shocked if the Dow dropped to 4,418 points, but this is what the “greatest Dow Theorist of all time” (Richard Russell) is predicting.

The stock market may, in fact, be putting in a top. The resultant problem, as stated by John Murphy of Stockcharts.com: “The most difficult thing to determine in market analysis is the difference between a market correction and the start of a bear market. They look pretty much the same.” I know from reading John’s forecasts that he believes we are still entrenched in a secular (long-term) bear market for stocks and that what we have seen since the October 2002 low is a bear market rally (or a mini” bull market) within the framework of a secular bear market.

Consider what John Hussman of the Hussman Fund, a very bright analyst, wrote on June 19, 2006: “In my view, the stock market remains richly valued, and investors should not rule out an S&P 500 trading in the 700-800 range in the years ahead as a reasonable (not catastrophic) probability. Investors should not be misled to believe that broad exposure to stock market risk represents sound investment here, or that a shallow decline of a few percent has suddenly made the stock market a bargain.”

John said if the S&P 500 were trading within a range of 700-800, it should not be considered catastrophic. But a drop to 700 would be about a 45% decline from current levels (as of this writing) and a decline to 375 on the S&P - well, that may be catastrophic, indeed.