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May 1, 2006

Hour of Reckoning

The idea of "one and done" regarding Fed hikes has captured traders' psyches and weighed on the dollar and Treasury bonds, while boosting metals prices. Today's action saw continuation of the recent dollar slump, which has now erased all of the gains seen in 2005. Ten-year Treasuries also slumped, sending the yield to 5.13%. Gold and silver popped again, sending silver back to the $14 mark and gold to a new high of $660.

With the subject of the demise of the dollar crossing so many headlines once again, the idea of exhaustion for the current move has crossed my mind. It wouldn't surprise me to see both the dollar and U.S. Treasuries put in a sharp reversals in coming days. In fact, the U.S. Dollar Index put in a bullish hammer with today's action. If such a reversal were to materialize, it could temporarily knock the wind out of precious metals. Likewise, housing stocks, which have been under a lot of selling pressure recently, could receive a reprise. On the other hand, should the homeys fail to rally in light of a bond bounce, it would be a sign of stronger underlying weaknessÂ… but perhaps I'm thinking too many steps ahead. One must simply be prepared to quickly jump in either direction based on what events unfold.

The development I find most perplexing is the failure of stocks to break down with the bond market tanking. Granted there is always lead time involved, but bonds have been going straight down for two months. Traders simply refuse to price any risk into equities, which makes me think that when equities finally break, they will break hard. The way equities cracked in the last half hour of trading today exemplifies how the daily or weekly charts could appear in the near future.

Today's last-hour crack was presumably sparked by a report on CNBC which quoted Bernanke as saying that the markets misinterpreted his statements to Congress last week. According to Bennie, he was only trying to provide the FOMC with flexibility in its decision-making process, not hint that rate hikes were about to end. My interpretation: he was upset that the dollar tanked after his comments. The Fed is accustomed to seeing stocks fly after such verbal prodding, but without damaging the dollar. I postulated such a train of thought in a response to a question in my most recent Q&A.

We could now be approaching an important inflection point, psychologically speaking. If the Fed comes out of its meeting next week leaving the door open for additional rate hikes, which I suspect will happen, the speculative fervor recently built into equities could unwind quickly and even catch some momentum.

The Fed's predicament is rapidly approaching its point of convergence. If the Fed quits, they will lose the dollar and spur inflation. If they persist, they will lose equities, housing, and the consumer. They can no longer have it both ways, though I suspect they will keep trying. As I wrote in last week's "All Asset Classes Are About to Correct," I think the Fed is about to disappoint the "one and done" crowd, spurring sharp sell-offs in both stocks and commodities. When the damage to stocks gets uncomfortable, Mr. Deflation will come to the rescue and print money like mad.

Disclosure: None

 

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