What If The Fed Succeeds In Turning The Economy Around

In the aftermath of the employment report one could almost hear the investment community asking the same question. What will the investment landscape look like if the Fed, Treasury and Administration succeed at turning the economy around?

The answer is unknowable, but the market suggests a few bets have changed. The most striking example of the reversal of thinking can be seen in the US Dollar trading before, during and after the report.

The initial reaction was an immediate sell-off in the dollar and a concomitant rally in US equity futures. For the last several weeks, the predominant and profitable line of thinking has been, “When you see green shoots, sell the dollar and buy equities.” However, that all changed on at 8:40am Friday morning.

In last Tuesday’s Surf Report, our headline was “It’s Alive,” a reference to Frankenstein and the Triple R rally. It appears that last Friday market participants finally got around to reading our Tuesday report!

So what will the investment landscape look like if the monetary and fiscal stimuli actually work? The first stop on our tour of the new outlook will be dollar-land. If the economy is recovering, then the need to print more money has ended. In fact, the Fed may actually be able to cease quantitative easing altogether. The implication is that those who have been fearful of a falling dollar due to oversupply are wrong. We are included in this group.

An economic recovery means that the Fed will begin to decrease the money supply. Recent Fed rhetoric has foreshadowed such an action. Many of the governors have become increasingly concerned with the Fed’s independence and are actively seeking an exit strategy.

A contraction in the money supply is precisely what Chairman Bernanke has been concerned about. His entire academic and professional career has been devoted to avoiding the mistakes made during the Great Depression. In particular, Chairman Bernanke has concluded that the Depression was exacerbated by the Fed’s inaction on a declining supply of money. The Fed Governors who are looking for an exit strategy will have a tough fight on their hands, as they should.

Now is not the time to talk about exit strategies and a contraction of the money supply. Sure, there are green shoots, but a farmer does not remove the fertilizer once the sprouts have sprung. There will be a time and place for such discussions, but now we must tend to the sprouts.

Attending to the sprouts may mean the rapid expansion of the money supply is over and that is enough to get the dollar moving higher. It is also enough for us to tighten our stops in our weak dollar trade, especially gold and silver.

The dollar also received a boost from the market belief that the Fed may actually raise rates. At one point on Friday the Fed Funds Futures implied there was 60% chance the Fed would raise rates by November! Once again an unlikely and detrimental scenario and once again we need to remind ourselves that we are trading the market not our opinions.

So where does that leave us? Let us summarize: the probability that the Fed will slow the rate of expansion in the money supply means the dollar may strengthen, coupled with higher rates (both actual and perceived) should attract capital to the United States. Our answer to the question “What if they succeed?”