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Friday, April 08, 2005

Perception Is Not Reality, Money Is

It seems that oil prices are dictating interest rates. Oil rises, interest rates increase, stocks and bonds go down. Oil pulls back, interest rates drop, stocks and bonds go up. Perception is not reality, money is.

Even though the U.S. economy uses 46 percent less energy per unit of gross domestic product than it did 30 years ago, higher energy prices are muting growth and creating stagflation. Energy costs run through the distribution chain. It costs more to manufacture, procure raw inputs, fertilize crops and transport the finished goods to market.

Energy costs and borrowing costs have risen, thats a double squeeze on profits. 1st quarter 05 corporate reporting will be disappointing for interest rate sensitive and semiconductor equities. There will be a temporary energy cost driven soft patch this 2nd quarter. These events will reinforce the markets optimism that the Fed will stop tightening this summer.

Rates although rising are still accommodating. Income growth has declined but is still solid. A pent up war chest of cash is burning a hole in the corporations pockets. There is a current underlying increase in corporate economic activity. Higher energy costs and the latency in public and private reporting mechanisms, mute the undercurrents being seen. Perception is not reality, money is.

If you lower energy costs, the muting effect of higher energy goes away. By raising interest rates and strengthening the dollar; material inputs, energy and transport costs go down. These seeds sow a self reinforcing acceleration, which pushes up operating rates, reduces slack in the economy, improves pricing power and pushes up inflation. Stagflation is eventually replaced with organic growth and inflation.

Stagflation and energy muted organic growth only raise interest rates temporarily. Investors should read any substantial pullbacks in energy prices as bullish for economic growth and bearish for bonds. It might be advisable to sell into any significant bond rally.

There are four FOMC meetings in the second half of this year. Judging from the eurodollar contract spreads between June and December, the bond market is not pricing in any interest rate increases beyond this summer. I expect the Fed to continue raising the federal funds rate to at least 4% by year-end and 10-year Treasury notes to rise past 5.5% by year-end.

After this summer, when everyone has gone short on the dollar, long on commodities and oil, and thinks that rates will stop rising, that's when an acceleration of organic economic growth will formally be acknowledged. It will be too late for the Goldilocks and Rip Van Winkle's in this market. Perception is not reality, money is.


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