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| Fed should follow the money as well as the data | | By: Jennifer Ablan | | Sun Oct 22, 2006 6:43 AM ET
(Pic)- Early summer storm clouds gather over the U.S. Federal Reserve Building before an evening thunderstorm in Washington June 9, 2006. REUTERS/Jim Bourg
NEW YORK (Reuters) -The Federal Reserve has made clear that it's following the "data." But lately, economists and investors have been following the money, too.
The Dow Jones industrials <.DJI> and other major equity indices have climbed impressively this year. So have "junk" bond prices and emerging market securities. In some cases, asset prices have even set record highs. That suggests that, rate hikes and sell-off scares notwithstanding, liquidity is still abundant and sloshing through the world's financial system.
It's not just the Dow reaching 12,000. On a year-to-date basis, junk bonds are up more than 8 percent, emerging market debt about 7.50 percent, the Standard & Poor's 500 <.SPX> more than 11 percent and small-cap equities more than 15 percent.
On the other end of the credit spectrum, the 30-year Treasury bond has posted negative total returns of over 3.50 percent and 10-year Treasury notes at negative .01 percent.
"Watching the market action these days, I can't shake the picture of contestants at a pie-eating contest, shoveling the food into their mouths faster than they can possibly chew or swallow," Stephanie Pomboy, an economist and financial analyst at MacroMavens in New York, wrote in her latest report.
"With only 10 weeks left on the clock, investors are stuffing themselves silly on the empty-calories of high-risk assets -- hoping they will take home the double-digit return prize."
Since the fourth quarter began, junk yields have declined 30 basis points while investment-grade bond yields have risen 13 basis points, observes Pomboy.
"The last time investors went on a risk binge of this magnitude was back in April. Ya know, the month right before May," she said. "We all remember what it felt like coming off that sugar-high."
In May and June, risky junk bonds, emerging-market bonds and other exotica sold off sharply triggered by inflation worries.
Those worries could derail the financial markets again. With the core consumer price index, which strips out food and energy, jumping to 2.9 percent from a year earlier in September, interest-rate cuts that many were looking for might be delayed well into 2007.
Core prices up 2.9 percent are well above the 1.5 percent to 2.5 percent Federal Reserve's comfort level.
But the Fed's comfort level in inflation, or lack thereof, appears more worrisome when looking at it in other places.
"The whole problem is that Fed officials define inflation way too narrowly," said Pomboy. "They are only looking at inflation in the economy. Meanwhile, they've inflated one bubble after another in assets, especially in housing, which has seen prices deflating."
Dan Fuss, vice chairman of Loomis Sayles and co-manager of the Loomis Sayles Bond Fund, agreed: "The world is still awash with liquidity," as reflected in financial assets.
These days, the impact from liquidity that normally would flow into consumption has been diverted partially to financial market consumption, added Fuss. That is why the Fed should not only follow the data, but the money as well.
Pomboy summed up this way: "If financial assets start to deflate the way housing prices have, then the Fed would really be in big trouble to focus on economic inflation, even as it starts to retreat."
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