Earnings are soaring, the few remaining bears have been discredited, the stock market has been making new highs, the housing bubble is headed for a “soft landing” and Goldilocks doesn’t have a care in the world.

To top it off, BusinessWeek is reporting A Do-Nothing Fed Is Looking Less Likely.

The notion that the Federal Reserve will be cutting interest rates next year is rapidly losing support on Wall Street. The idea was pushed hard in the third quarter by several big-time players in the bond market who believed the housing slump would hammer the economy, and it was responsible for a huge bond rally that pushed Treasury yields sharply lower across the maturity spectrum. Now most analysts have seen the light. Yields, while still low, are heading up again, and stock investors seem happy in the belief that maybe the Fed will be on hold for quite a while.

However, investors beware. Several factors are coming together that could cause the Fed’s patience to wear thin. By the Fed’s own accounting, there is not as much slack in the economy as its policymakers saw only a few months ago. That means the economy has less room to grow without putting added pressure on inflation. Further complicating that issue, the economy appears to be regaining some momentum in the current quarter, especially from faster consumer spending. The new risk: Inflation could remain stubborn enough to provoke the Fed into raising rates sometime next year.

For now, Wall Street seems to be buying the Goldilocks scenario–an economy that’s not too hot and not too cold. However, chances are increasing that this porridge could start to heat up, a situation that would begin to try the Fed’s patience.

Indeed various Fed members have been stressing the need to closely monitor inflation. Following are a few snips from recent speeches by some Fed members.

  1. Recent information suggested that price inflation might be picking up slightly and only partly as a direct result of increases in energy prices.
  2. The members saw substantial risks of rising pressures on labor and other resources and of higher inflation, and they agreed that the tightening action would help bring the growth of aggregate demand into better alignment with the sustainable expansion of aggregate supply.
  3. Even with this additional firming the risks were still weighted mainly in the direction of rising inflation pressures and that more tightening might be needed.
  4. Looking ahead, further rapid growth was expected in spending for business equipment and software.
  5. Even after today’s tightening action the members believed the risks would remain tilted toward rising inflation.

The above snips can be used to emphasize just what BusinessWeek suggests: “Inflation could remain stubborn enough to provoke the Fed into raising rates sometime next year.”

No sooner that I finished typing that sentence, and without even opening the Mish telepathic message lines, I was flooded with questions. Inquiring minds are wondering if I am throwing in the towel on deflation.

The answer is “Not at all”. You see the above five quotes were not from recent Fed speeches (although they sure sound like it), but rather from the May 16, 2000 FOMC minutes.

Flashback May 2000

Over the next 18 months the CPI dropped from 3.1% to 1.1%, the US went into a recession, and capex spending fell off the cliff. What happened was simple: “Nobody saw it coming” and by the time they did it was too late to do anything about it.

The Yield Curve

“Yields are heading up”
said BusinessWeek. Is BusinessWeek looking at what I’m looking at?
Here is the yield curve as of October 31, 2006 with thanks to Bloomberg.

Hmmm. Is that a 54 basis point inversion between the 5 yr and 6 month treasury?
Hmmm. Is that a 69 basis point inversion between the 5 yr and the Fed Fund rate?

Please consider TLT, the 20yr+ Lehman bond fund.

Given that TLT rallies when long term yields collapse, it seems to me that the treasury market sees “something” is coming and that something is not Goldilocks. Could it be the treasury market sees rising foreclosures, rising unemployment, a falling CPI, and a slowing worldwide economy?

Foreclosures

RealtyTrac is reporting U.S. Foreclosures Up 43 Percent From 2005.

IRVINE, Calif. – Nov. 1, 2006 – RealtyTrac™, the nation’s leading online marketplace for foreclosure properties, today released its Q3 2006 U.S. Foreclosure Market Report showing that 318,355 properties entered some stage of foreclosure nationwide during the third quarter of 2006, a 17 percent increase from the previous quarter and a 43 percent yearly increase from the third quarter of 2005.

“Higher interest rates and a general softening of the real estate market are the two key factors contributing to the 43 percent increase in foreclosure filings from the third quarter of 2005,” said James J. Saccacio, chief executive officer of RealtyTrac. “What our third quarter research appears to be showing is that the first wave of adjustable rate mortgages is having a negative impact on the number of homes going into foreclosure. With the volume of these loans — more than $1 trillion of them due to adjust over the next 15 months — this is a trend that definitely bears watching.”

Colorado posted the highest foreclosure rate in the nation for the second consecutive quarter, reporting one new foreclosure filing for every 127 households — 2.9 times the national average.

A 55 percent spike in activity catapulted Florida into leading the nation in total foreclosure filings during the third quarter. Texas, which led the nation in foreclosure activity for the first two quarters of the year, moved into second place, reporting 39,363 properties in some stage of foreclosure. With a 35 percent spike in activity, California rounded out the nation’s top three, reporting 37,317 properties in some stage of foreclosure for the three-month period.

Even though interest rates were hiked 17 consecutive times (a new FOMC record), and even though it was widely understood that $1 trillion in mortgages would reset in 2007, and even though the bottom fell out on credit standards, I am quite sure that “Nobody Could See This Coming”.

As preposterous as that might sound, I have proof.
Please consider the Bloomberg article UBS Reports 21% Drop in Third-Quarter Profit on Lower Trading

UBS AG, Europe’s biggest bank by assets, said third-quarter profit fell 21 percent, missing analysts’ estimates after trading revenue dropped at its securities unit.

“Nobody saw this coming,” said Florian Esterer, a fund manager at Swisscanto in Zurich, which oversees about $40 billion, including UBS shares. The combination of market swings and rising costs for staff and technology “were just too much,” he said.

At UBS, proprietary trading revenue fell, in part because the bank was “incorrectly positioned” in the Treasury market, the company said. Treasuries posted the biggest gains in four years in the third quarter on speculation a slowing economy would reduce the likelihood of further Federal Reserve interest rate increases.

Incorrect Positioning

UBS was “Incorrectly positioned” in the Treasury market, huh? Fancy that. I am quite sure we are going to see a lot of “incorrect positioning” going forward. This is simply the way it HAS to be. Before a deflationary credit crunch can set in, bears have to embrace the rally (and except for a few diehards they are), the masses have to embrace the Goldilocks scenario (and they are), housing has to look like a soft landing is possible (and most think so), and the Fed HAS to seem more worried about inflation than deflation (and without a doubt they are).

In 2000 the Fed was worried about inflation right at the outset of the dotcom bust.
In 2002 the Fed was worried about deflation in the aftermath of the dotcom bust. The Fed lowered interest rates to 1% even though consumers never stopped spending and housing was going strong. It was the wrong fear at the wrong time. In fact, those actions by the Fed set in motion the very thing they feared: a deflationary bust, not of dotcoms but housing, something far far bigger.
In 2006 the Fed believes a soft landing in housing is coming, inflation risks are to the upside, and wages and jobs are picking up nicely.

The stage is now set for a massive number of “Nobody Could Possibly Have Seen This Coming” proclamations. When they come, please point them here.

The above article originally appeared in Whiskey & Gunpowder.

Mike Shedlock / Mish/