U.S. Fed in the Hot Seat

Xie’s article entitled "Tight Spot for Fed, Blind Spot for Investors" explains succinctly how the U.S. Federal Reserve is caught between a rock and a hard place, after committing to a US$12 trillion stimulus package to bail out the financial system. It is caught in a dilemma on whether to keep interest rates artificially low, which might further depress the already weak dollar caused by a steady outflow of smart money that is wary of the massive money supply overhang (the author thinks) and hence force inflation expectations even higher, or to hint a rate raise, which might stamp out any so-called green shoots in the still ailing economy.

Xie suggests that given currently rising Treasury yields and oil prices as well as relentless weakness in the dollar, signs are visibly clear that many are betting that the Fed’s stimuli will translate into rampant inflation without actually helping economic growth (based on the ‘rational expectation theory’). Stagflation will not only be inevitable, but will cause global stimulus to lose traction and the global economy to slump, unless U.S. policy makers take action to allay market concerns about the government’s rampant fiscal and monetary expansion, by assuring the public that the stimulus money will be withdrawn as soon as practicable. However, rhetoric, even if used, will only buy some time and fool the market for a while longer. By 2010, it will be clear that the U.S. will have no alternative but to print more money, and a second dip for the global economy will take place, according to Xie.

Towards the end of the article, Xie makes an interesting observation, with which I agree:-

"This institutional weakness (that the finance sector is biased towards bullish sentiment) has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than those who held U.S. market bonds, and who lost big in Japan and emerging markets in general. It is astonishing that a value-destroying industry has lasted so long. The greater irony is that salaries in this industry have been two to three times above what's paid in other sector. The key to its survival is volatility. As markets collapse and surge, possibilities for getting rich quickly are created. Unfortunately, most people don't get out when markets are high, as they are now. They only take a ride."

Lastly, the author laments that governments around the world, instead of focusing on genuinely needed reforms, have been trying to take the easy way out and blow a new bubble to gloss over existing problems.

Hence, his advice for investors is:-

"If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can."