August 9, 2011

Why Today's Dow Jones Recovery ISN'T Rainbows & Unicorns

The Dow Jones (DJIA) rebounded by over 400 points today after yesterday's Monday reaction to the Friday downgrading of the U.S. government's credit rating.  The market rebound is being attributed to the Fed's comments today that the interest rates will not change for the next two years.  Good news if you believe it.

How on earth can the Fed commit to long term interest rates?  It's never done so before, and it really doesn't have control over long term interest rates just as people don't control global climate.  So the rebound is based on rainbows and unicorns and it isn't supported by reality.

Never mind the risk of creating a new bubble by doing something that's never been done before and that the Fed can't really guarantee.  What the bigger concern is that the government has locked itself into a course of action that supposedly will spur business investment based on a certainty that has never existed in history.  It also keeps government debt repayment lower with lower interest required.

But pressure will build up on that reality - either the government has no ability to do more quantitative easing by 'printing money' and thereby pushing up inflation and logically interest rates (oops - can't do that now) OR else the government will find a need to provide more quantitative easing and the dam will burst on the promise.  In the latter case the snap back reaction will be bad for markets.  The Fed breaking a promise it had no business making will shake the market.

The only way this works is if the economy stagnates and we stay stuck where we are through 2013.  If that's the expectation, then the Federal Reserve has put the death stamp on the latest summer of recovery and next year's version too.  It may be a death sentence for the Obama presidency.  In that sense, maybe there is some upside to this - it's Bernanake's version of the Standard and Poors downgrade, except it's on the president.  Let's let that reality sink in.  Enjoy.

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