US Interest Rate Cut Leads to Inflation Fears, Gold Price to Rise Fast

If the characteristic mark of a selling panic is that everyone is on the same side of the market, and they are selling everything — the good, the bad, and the ugly — the action immediately following the Fed’s surprise rate cut two weeks ago could be described as a buying panic. Everything went up. Most everything is still going up, except for currency, bond and home prices, disregarding the occasional backfilling on the way to higher ground.

Bernanke’s surprising interest rate cuts deserve much of the credit – or the blame – for the stock market’s dazzling performance. The S&P 500 just posted its biggest quarterly gain since 1998. But rate cuts don’t always produce a lasting magical effect. In fact, they sometimes produce no magic whatsoever. A look back at previous rate-cut cycles may shed some light on what we should expect this time around.

In the next 1,047 words, I’ll show you what happened to the stock market after past rate cuts. To give away a partial conclusion, stocks tend to rise. There are important reasons why that may not happen this time. But first, let’s take a look at what the Fed did on September 18th.

The Bernanke Fed used the element of surprise to its advantage. It lowered its target rate 50 basis points (0.50%). The Fed also cut the rate it charges banks on loans directly by 50 basis points (0.50%). The markets expected half that.

In its prepared statement, the Fed said it was worried about the effects of tightening credit conditions on the economy, and that its rate cut was “intended to help forestall some of the adverse effects on the broader economy…and to promote moderate growth.”

Incidentally, the Fed also expressed concerns about inflation. But talk is cheap. If the Fed was genuinely worried about inflation, it would not have slashed interest rates when the risk of rising inflation is so obvious. The Fed would not have slashed rates when commodities like gold, oil and wheat are threatening to make RECORD highs and the US dollar is slumping toward historic lows.

On the other hand, Bernanke probably realised that an “expected” rate cut would have caused stock prices to head straight down. In other words, he was “targeting” asset prices, primarily to try to rescue America’s major lending institutions from the consequences of their reckless lending and speculating.

The stock market responded as hoped to Bernanke’s surprising rate cuts, while both the dollar and gold responded as feared. Even after yesterday’s selloff, the gold price has jumped more than 10% since the Fed started cutting interest rates in mid-August. And why not? Bernanke’s dramatic rate cuts have been the best buy signal for gold since the news of his appointment as Federal Reserve Chairman.

Meanwhile, the dollar has dropped to new all-time lows. Unfortunately for the Fed, therefore, the message of the tape is that the market is worried about inflation. And inflation is not usually a friend of the stock market.

Former Fed Chairman, Alan Greenspan, compares the recent crisis in the financial markets to the crises of 1987 and 1998. As it happens, both of these financial crises prompted a one-off rate reduction, which apparently pre-empted a recession. And the stocks markets recovered promptly. There were no follow-up rate cuts. Perfect! So, the thinking goes, this is gonna be just like those other times. The rate cut is just one helluva insurance policy. It’ll pre-empt recession and it’ll boost share prices.

I look at it differently. This is not 1987 or 1998. Indications suggest that today’s crisis is bigger and more widespread than either 1987 or 1998. We know it reaches beyond US borders. Moreover, the bull market in the years leading up to 1987 and 1998 was on sounder footing — both periods saw a relatively benign price and economic environment in the U.S….commodity and other prices weren’t soaring like they are today.

Yet another important difference between today and both 1987 and 1998 is that the Fed did not react until the stock markets were off some 20-30% in these latter periods. Today, the market was only 11% off its all-time high, at worst! Aside from those two instances (and 1995), there has been no other year since 1950 when the Fed cut rates by less than 1% without follow-up rate cuts.

It did cut rates in 11 other instances, but those were actual campaigns, lasting anywhere from nine to 40 months, averaging about 600 basis points (6%) in rate cuts – and nothing less than 200 basis points.

In nine of those 11 instances, a recession occurred anyway.The average return on the Dow in the 12 months following the start of all 14 Fed rate-cutting campaigns since 1950, excluding dividends, was about 16%. Excluding the one-off campaigns of 1987, 1995, and 1998, which saw the Dow gain an average 26% in the 12 months following the first rate cut, the average return (excluding dividends) on the Dow falls to 14%. If we further reduce the sample to those instances in which the Fed began cutting rates before the Dow fell more than 10% (1960, 1980, 1981, 1989, 1995, and 2001), as today, the expected return falls to 9%. We would also point out the S&P 500 has ALREADY gained 9.6% since the Fed began cutting interest rates on August 17th!

Excluding 1995, this expected return falls to just 7%, which is a far cry from the 22%average returned in instances when the Fed waited until the stock market was down over 20%. Moreover, in two of the instances above (1981 and 2001) in which the Fed started cutting rates before a significant correction in stock prices, the returns were actually negative in the 12 months subsequent.

History suggests that rate cuts tend to work out better for stocks when they start after a major stock price correction (more than 15%) when the inflation and price environment is relatively benign and there is no profit or economic slump. In the current situation, the Fed is missing at least two of these conditions. An even greater risk for the Fed is that if the stock market doesn’t sustain a rally, confidence in its future policies will falter.

Since the stock market has already gained more than 9% since Bernanke’s rate cuts began, the stock market’s risk-reward profile has shifted toward risk…while gold’s has shifted toward reward.

Buying gold and other hard assets is probably not the worst way to protect yourself against the excesses of “New Era” central bankers like Ben Bernanke, or against the goof ups of bureaucratic policymakers in general.

The dollar’s fundamental underpinnings have become so feeble and suspect that gold is not simply likely to advance in price like everything else; it is likely to rise faster and farther than almost any other asset.

The investment follow-through in coming weeks will be telling. But after some normal profit-taking from the US$740 level, along with a possible re-test of the US$700 floor, I’m looking for gold to break to new record highs above US$900, and maybe even through US$1,000.

And when it does, just say, “Thanks Ben!”

Ed Bugos
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• None Found