Tuesday, June 18, 2013

Tuesday, June 18, 2013 - The Fed, and the Brazilian Protests

The Fed, and the Brazilian Protests
by Sinclair Noe

DOW + 138 = 15,318
SPX + 12 = 1651
NAS + 30 = 3482
10 YR YLD + .01 = 2.18%
OIL + .63 = 98.02
GOLD – 16.40 = 1369.30
SILV – .16 = 21.78

The past couple of years, the financial markets have been very dependent on the Federal Reserve, perhaps overly dependent. Much of the fundamental analysis of companies and the economy has taken a backseat to the Fed's unprecedented monetary policy of Quantitative Easing. The outlook for the financial markets for the remainder of the year boils down to potential changes in policy. The Federal Open Market Committee has begun its regularly scheduled policy meeting and tomorrow they will issue a policy statement followed by a press conference by Fed Chairman Bernanke.

So, this time tomorrow we'll know more but given the importance of monetary policy, it's worthwhile to consider possibilities and possible market response. There are four possible scenarios to consider:

The first scenario has the Fed announcing preparations for tapering off QE; they won't actually stop QE tomorrow, they'll just announce their intention to exit QE policy at some identifiable point down the road; and of course, it would be conditional on economic developments between now and the determined exit date; it would most like involve scaling back securities purchases without any specific targets for changing interest rates. This seems to be the most probable scenario right now.

Since the Fed announced QE3 last September, the Bank of Japan has started their own $75 billion per month stimulus policy, known as Abenomics. There are fears that the combination of QE3 and Abenomics might have a destabilizing effect. There is no indication the Japanese are backing away from their stimulus program, and there is indication the Euro-zone might consider some sort of monetary stimulus program. So, if the Fed backs down, that leaves room for other central bankers to maneuver.

The other three scenarios for tomorrow's announcement are far less likely. The Fed could announce an immediate tapering off from securities purchases; this is not likely; former Fed Chairman Greenspan tried this in 1994 and it was messy. The only reason the Fed might try this is to shock the markets, inducing a flight to safe havens such as Treasuries, and applying pressure on the politicians to come up with something that resembles fiscal policy. This is risky, like dancing on a carpet of banana peels.

The other scenario involves the Fed announcing that it is continuing with stimulus but it will consider a different mix. In other words, instead of buying $85 billion a month in Treasuries and mortgage backed securities, they will consider other purchases. They might consider student loan debt or state or municipal debt. Again, this would be a bit of a shock but it makes some sense.

The housing market has benefited from the Fed purchasing mortgage backed securities; meanwhile, student loan debt is starting to resemble the subprime markets of a few years back; defaults are on the rise and a meltdown would be ugly.

Likewise, there are several municipalities that could benefit from an infusion of capital from the Fed. Several cities in California are bankrupt. Detroit is insolvent and facing the prospect of default on $17 billion, including pension payments. They have a tightrope balancing act between the legacy obligations to creditors, employees, and retirees and their obligation to the residents of the city to continue to provide basic services. Right now there are 30 fires per day in Detroit. If they cut back on the Fire Department, the whole city could burn. Yes, some of those fires are deliberate.

There are other areas the Fed could consider that would offer a more direct infusion of capital directly into the economy, and they could do this in small steps; stepping back from Treasury or MBS purchases as the markets fluctuate; stepping into brave new arenas as needed. This is a highly unlikely approach but it would offer the biggest bang for the Federal Reserve Note.

The final scenario is that the Fed doesn't change anything tomorrow. Why should they? When they announced QE3, they said they would continue until they reached a target of either 6.5% unemployment or 2.5% inflation. Inflation remains below the Fed’s 2% target. The core consumer price index is up just 1.7% year-on-year in May. The central bank’s preferred measure, the index for personal consumption expenditures, is up only 0.7%. The economy has been adding jobs but the unemployment rate still stands at 7.6%; that's a long way from the target. While some might consider tapering to be an indication the Fed thinks economic recovery is stronger than it looks, an exit from QE now would be an admission of monetary policy failure. Consider it the central bank equivalent of a “Mission Accomplished” banner.

The Fed may ultimately decide that the economy or the markets are simply not ready and that announcing any intention to taper in the coming months may cause more harm to capital markets than its worth. This leaves the Fed with the option to do more jawboning in the future; it leaves them with the option of shocking the markets; it leaves them with more time to figure out alternative monetary policy; and it leaves them with more time to try to see beneficial returns on QE3 before they burn that bridge. Maybe Bernanke would just as soon leave the exit from QE to the next Fed Chairman.

Whatever the Fed announces tomorrow, it will likely rattle the markets. Both stocks and bonds would likely have a party if the Fed holds steady with no changes. The markets love free money from the Fed and no change might just be enough to provide a summer rally; a little boost for the economy.

Stocks would likely take any tapering news poorly. Any news of intention to taper might be enough to push stocks into a summer swoon; and then we would wait to see if that leads to a full fledged bear. At the very least, it would take a little of the exuberance out of stocks. That might not be such a bad thing; the S&P 500 is up about 22% over the past 12 months; there has been a disconnect between the stock market at 20% and the broader economy, which has been growing at a little less than 2%. Any news of intention to taper would likely be positive for bonds in the short term with a flight to safety, at least that was the history following the end of QE1 and QE2.

Tune in tomorrow.

Yesterday, I mentioned that there had been quite a few protests around the world. I listed about a dozen locations where protesters had taken to the streets in huge numbers. I didn't even mention Turkey. I did mention Brazil, where the normally laid back Brazilians took to the streets. Yesterday, the Brazilian protests really picked up steam. It started on Saturday, when the FIFA Confederation Soccer matches began in Brasilia. President Dilma Rouseff was scheduled to make an announcement before the game. The government had spent about $600 million to build a beautiful new soccer stadium, part of the 2014 World Cup. Rousseff was booed relentlessly; she cut short her speech and quickly exited the stage.

You may hear that the Brazilians are upset about a rate increase in bus and subway fares. That's not what the protests are about, or at least it's just a small part. The Brazilians are upset that the government has spent tens of billions preparing for the World Cup, with allegations of corruption; projects are already vastly over-budget and we are a year away. Meanwhile Brazil continues to invest below the OECD average in education. Public health expenditure is even lower. People are going hungry.

Rio de Janeiro consistently ranks amongst the most expensive cities in the world, while minimum wage remains low, about $300 per month. Sao Paulo, the country's financial center is even worse. It is home to the highest concentration of private jets and helicopters in the world, but the lower and middle classes have no access to decent schools and hospitals; and the poor people rely on public transportation. When residents of the two cities took to the streets last weekend bearing placards and chanting slogans demanding answers, regional police responded by firing rubber bullets and tear gas and violent beatings.

In response, the Brazilians took to the streets yesterday in massive numbers. The official estimates were more than 100,000 protesters in downtown Rio; the unofficial numbers topped a quarter million. The international media has also been peculiarly disinterested on the subject, even if coverage of the protests in Turkey, similar in nature to Brazil's, has been extensive and detailed. Spain's El Pais suggested the Brazilian protests have left the international community baffled as the country is consistently painted as a model for growth and development; Brazil is now the world's sixth largest economy, growing rapidly; Brazilians have nothing to complain about.

Certainly the Brazilian government thought that the populace would be distracted by soccer; and while it is true that Brazilians love soccer, it turns out it wasn't enough of a distraction. While there has been economic growth, there has also been growing inequality, and growing poverty. And the World Cup has just highlighted the inequality. The minimum wage of $300 a month is the average price of one ticket to one World Cup soccer game. Soccer was once a game that brought all Brazilians together; now the World Cup just rubs their noses in the fact that they are further apart than ever.

The big reason inequality is now a regular topic of conversation among economists is that the rapid rise of a super rich class while average workers are left in the dust makes it impossible to ignore. The IMF and the World Bank have just released a report showing that at the same time US companies are taking down a record share of GDP in profits, our country’s ranking in inequality is worse than that of many developing economies. New York City is more unequal than China, and also more unequal than Russia, famed for its oligarchs, and India, which still has hundreds of millions living in abject poverty.

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