Wednesday, May 29, 2013 - Behind the Curtain

Behind the Curtain

by Sinclair Noe

DOW – 106 = 15,302
SPX – 11 = 1648
NAS – 21 = 3467
10 YR YLD - .01 = 2.12%
OIL – 2.12 = 92.89
GOLD + 11.30 = 1393.70
SILV + .19 = 22.56

Earlier today, I listened to one of the talking heads on CNBC trying to explain why the markets were up yesterday and down today. It was very entertaining.

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, and interest rates rose, the average life of the MBS portfolio would be extended for a few years. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries. The higher rates go, and the speed that rates are increasing, forces more and more selling.

Is there a level of support that we can watch? There is, and it's probably 2.2% to 2.5% on the 10-year bond that will bring out an avalanche of selling. The 2.2% tipping point is very close to where the T-bond sits today. Others say we have a huge concentration of bonds that would go out of the money around 2.5% - again, very close to where we are.

The more the price on the 10-year drops, and the higher the yield climbs, the more selling is required. Is the Big Sell-off going to happen? That depends on the performance of the bond market, and on how the dealer community is positioning themselves against event risk.

There are risks: generally speaking, and in regards to ‘taper’ of QE, soon as the Fed pulls back, we will see a spike/knee-jerk higher in rates (which we are seeing in ‘anticipation’ of this happening). Remember, all the movement we've seen in bonds in the past two weeks is just from jawboning about the possibility of taper.

Bernanke has recently said that the Fed is in the process of  changing the monthly QE purchases. Here's a big question to be considered – does taper of QE indicate the economy is better? That would be the reason to raise rates; the economy is improving – raise rates; everything else is artificial, or just an attempt to tamp down an impending asset bubble.

Yesterday, we heard that consumer confidence was up, a big jump in May to 76.2. It sounds like everybody believes the economy is improving. And while the confidence numbers are up, they're not out of the gutter. The average consumer confidence number during a recession is about 79, and even with our recent boost, we're still lagging below that low bar. The May data shows the highest measure of consumer confidence since February 2008. That was a time in which a housing crash was already well underway, and only a month before before Bear Stearns collapsed and confirmed that the country was in a financial crisis.

Yesterday, we also had the S&P/Case-Shiller House Price Index posting a 10.9% increase year over year in March. Well, that certainly sounds like things are improving. Except, in nominal terms, the Case-Shiller National index (SA) is back to the third quarter of 2003 levels. Inflation adjusted, prices are back to the second quarter of 2000. The biggest price gains were noted in Phoenix, Las Vegas, and San Francisco; all areas that were smashed by the housing crash. So, in some ways, the great rebound in housing is just another stage in the foreclosure crisis. And that is a crisis that is not yet finished.

Last year $192 billion-dollars was lost as a result of foreclosures.  On average per household, this number equates to about $1,700 of loss in 2012. The foreclosure crisis is still ongoing despite the fact that foreclosure volumes are on the decline. Why are the number of foreclosures on the decline? Last month, three major banks, including Citigroup, JPMorgan Chase, and Wells Fargo, halted all their sales of homes in foreclosure; this also reduced the supply of homes on the market. The apparent problem is that the banks still weren't following the rules for foreclosures, in violation of the national mortgage settlement. The reduction in housing supply, then, is largely artificial.

There is one thing that housing prices do accomplish, however: the so-called "wealth effect." Along with a booming stock prices, higher property values make people feel rich. This then encourages them to go out and spend money. Here's the problem with the wealth effect, you have to realize your gains. In other words, you would have to sell your stocks and your real estate and put the profit in your wallet, otherwise the wealth effect is so much smoke and mirrors, and you're spending money you don't really have. Which is one thing that Americans have apparently mastered.

Half of working Americans now earn less than they did 10 years ago, adjusted for inflation. Middle class incomes have barely budged in 44 years. Around 12 million people are unemployed, about 40% of whom have been out of work for six months or more. Remember the Summer of 2012? All the politicians were talking about jobs, jobs, jobs. Now, they can't even spell it. Poverty is on the rise, and it would be in your face and on the sidewalks except that now we have food stamps, so we don't have to look at the lines of people waiting outside soup kitchens like in the Great Depression. Still, 15% of the country depends on foods stamps.

For people who do have jobs, the quality of the jobs continues to decline, and if you were thinking about retiring, well, you probably are having to re-think your personal exit strategy. According to a recent Gallup survey, 37% of nonretired Americans claim that they will quit working after age 65. A decade ago, that percentage was 22, and in 1995, only 14% guessed they'd be retiring after 65. Is it possible that work is now more fulfilling for so many more people? Were so many employers discriminating against willing 65-year-olds a couple decades ago? Not likely. People are working longer to keep food on the table and a roof over their head.

Besides not having saved enough, today's would-be retiring baby boomers have more debt. The Census Bureau reports that from 2000-2011, the largest percentage increases in median household debt were in the 55-64 age bracket (up 64%, to $70,000) and the 65-and-over bracket (more than doubling, to $26,000). And while many were taking on more debt, median net worth (assets minus liabilities) for all age groups fell. In 2000, median net worth was $81,821. In 2005, median net worth had jumped to $106,585, before dropping to $68,828 in 2011 (in 2011 constant dollars).

In 1985 taxable money market funds were yielding 7.71%. A one-year CD was yielding 8.53%. Nowadays, CD's and money market funds offer rates that start with a decimal point. The Fed has been forcing people into the equity market and if you just don't have the stomach for stocks, you've been forced into the bond market.

The Fed's bond holdings alone have almost tripled since March 2008. And since last fall, the Fed has purchased mortgaged-backed securities and bonds by $85 billion each month. As a result, Fed's holdings in securities will amount to $4 trillion by the year-end of 2013. At the same time, the balance sheets of the big four central banks (the Fed, European Central Bank, Bank of Japan, and People's Bank of China) have more than quadrupled from $3 trillion to more than $13 trillion during the past half a decade.

As rounds of QE have pushed nominal interest rates below the rate of inflation in the United States, it was hoped that negative "real" interest rates would encourage lending and borrowing, and thus to stimulate economic activity. But this is growth by addiction, not growth by fundamentals.

Ben Bernanke knows this economy is not strong. This is no time to back away from trying to prop up the economy. Or as Bernanke said: “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

Is the economy in better shape than a couple of years ago? Yes, but it's a little early to break into a chorus of “Happy Days are Here Again”. While economic growth has picked up, it remains anemic at 2.2 percent real GDP growth on average since the end of the recession in mid-2009. As long as the US is growing well below potential; about 2.2 percent since the Great Recession/depression, inflation risks remain low and disinflation is the new normal, which serves as a still another reason to keep interest rates low. A lot of people would like to press the idea that the economy is improving; Congress can keep ignoring the unemployment and equality crises and enjoy ginning up imaginary problems.

“The loss of output and earnings associated with high unemployment reduces revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.” At least that's what Bernanke claimed in his recent testimony to Congress. Maybe Winston Churchill said It better: “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities.”

A mythical recovery gives cover to a lot of irresponsible people hoping that Americans won't look behind the curtain.