Interest Rates vs. Jobs: UUP, DIA, WMT, VZ, XLE

March 04, 2010, 08:00 am ET, BY Patrick- Contributor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

The question on many investors’ minds lately has been, “When is the Fed going to raise interest rates?” On Feb. 24, Fed Chairman Ben Bernanke addressed these concerns in his Monetary Policy Report to Congress stating that the federal funds rate is likely to remain exceptionally low for an extended period. However, as economic expansion matures, the Federal Reserve will at some point need to tighten monetary conditions to prevent inflationary pressures. While the Chairman was speaking, the dollar initially sold-off sharply, due to the implication that interest rates weren’t going higher any time soon. By the time Mr. Bernanke was done, though, the dollar recouped most of these prior losses. On the day, the PowerShares U.S. Dollar Bull Index (NYSE: UUP) finished essentially unchanged.

One of the key takeaways from the speech was that Mr. Bernanke wanted to provide some assurance that rates would remain low because the economy is still in a fragile state. The Fed has a huge challenge on its hands, though, as it tries to balance the risks of curtailing the economic recovery against the risk of rising inflation.

Unemployment Rate Is the Number To Watch

We have “technically-speaking” been out of the recession because GDP growth has resumed -- Q4 came in better than expected at 5.9% on Feb. 26. That news has been well-received by the stock market as the Diamonds Trust (NYSE: DIA) has steadily, albeit modestly, ticked higher since then. On the surface, the +5.9% looks quite impressive. But, it’s important to remember that GDP was near its worst levels of the recession a year ago, at -5.4%. As the year-over-year comparisons become less favorable, the growth in GDP is likely to moderate (the Fed forecasts 3-3.5% for 2010). This tepid forecast is the primary reason why the Fed expects rates to remain low.

However, there is one factor that can significantly alter those plans. The stumbling block for true economic growth has been the persistently high unemployment rate. If job growth starts to show signs of life, the Fed could look at monetary policy actions to curb inflation before consumer prices surge higher. But, on this front, the news has been bleak recently, as an increasing amount of initial jobless claims have been filed. There have been some well-publicized layoffs over the past month, including Wal-Mart’s (NYSE: WMT) cut-back at its corporate office, as well as announced layoffs at Verizon (NYSE: VZ) and Aetna (NYSE: AET).

With this in mind, the market will have its full attention on the latest unemployment rate on March 5, which is expected to tick up to 9.8% from 9.7% last month. This is troubling news in that it suggests a step-back in the road to recovery. What is uncertain is whether this is a one-time blip, or if we are tracking back to the 10% level. What we do know is that this adds more fuel to the fire in terms of keeping rates low.

Looking For Signs Of Inflation

 The trick the Fed has is to tighten monetary policy before inflation becomes a problem. It can’t wait around until oil prices zoom past $100/barrel. That would be good news for holders of the Energy Select Spider (NYSE: XLE), but not so much for the rest of America, because these higher gas and energy prices will be passed along to the consumer. We have already seen some initial signs that prices will be nudging higher as FedEx (NYSE: FDX) and UPS (NYSE: UPS) increased their shipping rates late last year. However, all in all, inflation remains in check at the moment, but the time will eventually come when it becomes a much bigger factor. Let’s just hope the Fed plays its cards right.

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