A Sudden Stop in the Making

Today the Fed released the Minutes to its May 10 meeting. The markets had been losing steam since the meeting because the Fed had made it clear "incoming data" was all important ... and the incoming data indicated higher inflation (a high number in March was followed by another high number in April) and more depressed housing/consumption (e.g., housing starts, home sales, consumer confidence, Walmart sales)... which meant either higher rates (in the case of higher inflation) or lower profits (if output slowed down), neither of which is good for the stock markets. To complete the picture, oil price rose and rose, above $72 a barrel of WTI, light sweet crude oil

So the markets were very nervous for several weeks ... particularly Emerging Markets, which lost most of their 2006 gains in the days between May 8 and May 24th (a 15% percent drop in 13 trading days). Between May 25 and 30, emerging markets seemed to hold on to life, but barely. Today, the Dow and even the MSCI - EM started off optimistic, maybe on the hope that the minutes would allow us to get in to the Fed's head, which at last would allow us to figure out what little bit of data we should really worry about.

The actual release was greeted with horror by the market (with a 0.58% drop in the DJIA), because it said the "Fed Explored Half-Point Increase in May." More specifically, it said that although 50 basis points were a possibility, so was a pause, and that a quarter-point made most sense.

However, it mentioned inflation and prices in unflattering ways a ton of times, and it said core inflation was becoming unacceptable, that oil and energy prices, together with a weak dollar, rising inflation expectations, and a high rate of capacity utilization, suggested that inflation would rise. All of this would stop being a problem if output behaved nicely and moderated over the rest of the year ... but that's still a hope rather than a reality.

Or is it? As they pointed out, the Fed has taken short-term rates to neutral or above-neutral territory; long-term rates are rising, if ever so slowly; the housing market is definitely cooling off.

The fact that housing is not collapsing doesn't matter, from my point of view: insofar as consumption has been fed by extremely high rates of borrowing (see the Fed's Debt Service Ratio and Financial Obligations Ratio) due to "never-before-seen long-term rates" and "never-before-seen housing appreciation rates", a moderation of long-term rates and housing appreciation to historical levels should cause high-flying borrowers to stop borrowing, and therefore to stop consuming. So it's natural to expect for a fall in consumption (it's 6 points of GDP higher than average, right now), which should lead to a compounded fall in GDP and employment (unless exports come in to save the day as the USD falls ... investment might contribute, precisely because capacity utilization is so high).

Now, here's a key sentence:

Still, it seemed most likely that, with modest further policy action, including a 25 basis point firming today, growth in activity would moderate gradually over coming quarters, pressures on resources would remain limited, and core inflation would stay close to levels experienced over the past year.

So, the Goldilocks economy may stay, neither too hot nor too cold, but only with more Fed action, of which May 10's was only a part. Inflation could worsen, and they worried about that, but then again it might not. Inflation expectations matter, but then again, they are not unusually high.

And what did this do to the Emerging Markets? Poor emerging markets. The MSCI - EM fell on impact and has kept falling, losing breath it had caught since last week. Bovespa gained and lost, MerVal is throwing fits, Mexico's IPC is falling... (see also Chile's IPSA and Peru's).

A sudden stop in the making.