I still think that "How far will the Fed go?" is the question of the moment. With that as a backdrop, let's look at how things might play out over the next six months.

First, as I have maintained for over two years, the Fed is going to raise rates higher than most market observers anticipate. That has been the unerring pattern for 90 plus years. When the May Fed rate hike was announced, most observers saw the accompanying release as a message that the Fed was going to pause in June. I disagreed. It is now almost a lock that they will raise rates by at least another 25 basis points next week.

The next Fed meeting is August 8. They will have the first estimates of GDP for the second quarter. My guess now is the number comes in above 3%, which along with another uncomfortable inflation number in July will give them reason to raise rates yet one more time. That will take the Fed funds rate to 5.5%.

Unless, and this is a big unless, the August and September inflation numbers come in sequentially higher than July's number, I think we will see the Fed finally pause in September. But the Fed will be driven by the inflation data.

The yield curve will be fully and decidedly inverted in August, as opposed to flat which it will be after next week's raise it rates. The economy will be starting to slow and we should see long rates begin to drop, which will make the yield curve even more inverted by the end of the third quarter.

What could change that scenario? If the July inflation numbers come in somewhat lower than 2% on an annual basis, thus indicating that inflation is already peaking and if the GDP number comes in less than 3%, suggesting the economy is slowing. That would let the Fed pause in August.

In that case, long bond rates will still drop and the yield curve inverts and the economy slows anyway.

A Slowing Economy Is Not the Issue

Let me emphasize again, the Fed is aware that the economy may be slowing. A slowing economy is not their primary issue. The Leading Economic Indicators index declined 0.6% after a 0.1 % drop in April, the Conference Board said today. The last time the gauge fell in consecutive months was February and March 2001. Seven of 10 leading indicators had a negative effect on the May index.

Dennis Gartman pointed out to me this morning that his favorite predictor of the direction of the economy and recessions once again dropped. He watches the ratio of the current to the lagging indicators. As he wrote:

"Worse, however, for the economy was the fact that the Coincident indicators rose 0.1% while the Laggers rose 0.2%. Although both were higher, the ratio continues to fall, and as long as the ratio falls we are more and more confident that the US economy is headed at least toward a material slowing of economic growth in the 3rd or 4th quarter of this year, or that it is heading for recession itself."

Also note that the current data still suggests the economy is strong. Unless something changes in the next 10 days, I think the August GDP data and the July inflation numbers will force the hand of the Fed to raise at the August meeting.

Why? Because of the sacrifice ratio. Bernanke is a big believer in this arcane number. In a very imprecise definition, it is the amount of sacrifice you make in unemployment today to ward off inflation and bigger problems tomorrow. The sacrifice ratio is still high, which suggests that the Fed needs to err on the side of fighting inflation. The absolute worst situation would be for inflation expectations and actual inflation to take hold while an economy is slowing. Can you say stagflation, boys and girls?

It would force the Fed to induce a serious recession, as Volker was forced to do in 1980 and 1982. That is not an outcome the Fed wants to ever see again, or even get close to. Flirting with a return of inflation on the chance the economy might soften later is a very big risk. So, I think they risk an economy which might soften more than market participants are comfortable with.

If it does start to soften and inflation starts to fall, then they can always come in and lower rates. In fact, it would not surprise me to see them do so before the end of the year or at least in the first quarter of next year.

Let me make one prediction that is almost 99% certain to come true. If we do enter a recession or a real slowdown, the public will blame poor Ben Bernanke. Media mobs will form, looking for rhetorical rope with which to hang him. I read with interest an article on day trading in India quoting small traders that blamed Bernanke for the recent severe weakness of the Indian stock market.

R.I.P, The Yen Carry Trade

Poor Ben. The real culprit is one Mr. Fukui, who is the Governor of the Bank of Japan. (Do not ask me how to pronounce that name.) While central bankers everywhere are in a struggle to prove their manliness by being harder on inflation than their peers, Mr. Fukui has shown to be the clear cut champion. They have taken massive amounts of liquidity out of the Japanese system in the past few months.

George Soros, commenting last week, brought home the point:

"I think we are in a situation where almost all the asset classes will be under pressure or are under pressure and the main reason for that is the reduction in liquidity. What people do not realize is that the Japanese Central Bank has withdrawn something over $200 billion worth of excess liquidity from Japanese banks. Now that money was not put to work in Japan because there was no room for it, a lot of that went abroad, went into emerging markets, there was a so-called carry trade and it is not that suddenly people are risk averse. It is really that liquidity has been drawn out of the market and that is affecting emerging markets."

$200 billion in a global economy may not sound like a lot. But remember this was money in fractional reserve banks. They could easily multiply it several times. Pretty soon we could be talking a trillion dollars. Much of it went into providing cheap liquidity to global hedge funds and aggressive investors and banks. Thus, as the leverage went away, these groups started liquidating their very profitable emerging market trades, their commodity trades, and so forth. Everything began to go down at once. Markets that had not been historically correlated all of a sudden went down in tandem to the drumbeats of margin clerks everywhere.

To get an idea of how seriously the Bank of Japan has reduced liquidity, let's look at the following chart from my friends at GaveKal.

There have been three large run-ups in the Japanese monetary base in the last 30 years. Not so coincidentally, there were three large periods of asset inflations which accompanied them. When the Bank of Japan began to tighten, we had resulting deflation of those assets. As I quoted GaveKal last April:

"Looking at the past thirty-five years, we find that the Japanese monetary base has been allowed to double over short periods (i.e.: less than three years) three times. Each time, it led to massive bull markets (real estate, share prices, commodities, gold, etc...), followed, some time after the expansion of Japan's money supply was over, by a serious market downturn. Will this time prove any different? So far, it has."

That was at the end of April. At the end of June we can see that it has not been any different. World stock markets have dropped precipitously along with commodity prices.

For several years, speculators have been able to get very low interest rate money in a currency that was purposely being held down. It doesn't get any better than that. Low cost money encouraged speculation in every corner of the investment world. Not just stocks and commodities, but high yield and emerging market debt. The yen carry trade fueled the investment world.

Now Japan has said not only are we going to take massive amounts of money supply from the world, we are going to raise rates and allow the yen to rise. All that "free" money investors and businesses around the world borrowed is going away. It is going to become far less than free. By-by carry trade. Fukui indeed.

We are now going to look at three charts from GaveKal's latest quarterly. They tell a chilling story.

"In our world, two actors can create money out of thin air: the central banks, and the commercial banks. Over the past year, the world's central banks have been busy draining liquidity from the system.

"While the central banks were busy taking money away, the commercial banks were happy to multiply whatever money they had at an ever faster pace. This is now changing; with the increase in volatility, commercial banks are pulling back. As Mark Twain once said, commercial banks lend you an umbrella, then take it away once it is raining."

(Velocity in the next chart is a way to measure commercial lending growth.)

"The divergence between the action of central banks and the action of commercial banks recently reached unprecedented levels. In the past (1997, 2000), once the commercial banks got a whiff of the message the central banks were attempting to convey, they changed their behavior rapidly, and uniformly. Will we now witness a sharp snapback as we did in 1997 and 2000?"

OK, remember they asked the question in April whether Japan taking liquidity off the table would be different this time? It wasn't. And my bet is that commercial banks will also start the process of taking liquidity off the table as well. Loan committees are going to tighten their requirements on all types of lending. Get used to it.

Between the central banks of the world almost universally tightening, commercial banks poised to tighten and the US housing market looking like it is going to slow as interest rates rise, it is very likely the US economy is going to slow down in the last half of the year. The question is, "How much?"

I do not think we will be in an actual recession by the end of the year. But a recession is not out of the question for 2007. If the Fed does not have to go too far (and 5.5% may be too far given the other conditions in the world), then we could see a slowdown on the order of what we saw in the mid-90's. We will have to watch the yield curve and other indicators.

In any event, whether it is slowdown or recession, I think investing in the broad stock market is particularly risky. If you are good at picking stocks and know the companies you are investing in, that is one thing. But most readers invest in mutual funds and broadly diversified stock portfolios. Bluntly, I think there is some real risk to the downside.

And if the US economy slows down, so will the housing market and so will the US consumer. That will be a drag on the world economy and world growth in consumption. If the world slows down too much, you could see oil drop back into the $50's or even $40's.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor.  Contact John at John@FrontlineThoughts.com.

Disclaimer
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.