Friday, February 28, 2014 - Tantrums

Tantrums

by Sinclair Noe

DOW + 49 = 16,321
SPX + 5 = 1859
NAS – 10 = 4308
10 YR YLD + .02 = 2.66%
OIL + .05 = 102.45
GOLD – 5.10 = 1327.70
SILV - .06 = 21.30

Broadcasting from the Renaissance Esmerelda in Indian Wells for Financial Fest Palm Springs edition.  

Remember last summer when various Fed officials floated the taper balloon? The hinted that the Fed might taper from $85 billion a month in QE asset purchases. The result: Wall Street had a taper tantrum; the yield on the 10 year note spiked up to 3%; mortgage rates shot up and made many question the strength of the housing recovery; stocks swooned as the froth escaped the market.

The tantrum didn’t last long, even when the Fed announced the actual taper. Markets treated the announcement with a yawn. Stocks resumed their climb to record highs; Treasuries settled down; the housing market, well that’s always a local story, so it depends; and the economy continued to muddle. The markets seemed to accept the idea that the economy could handle a little less Fed stimulus, after all, they gave forward guidance that interest rates would remain low until the cows come home.

In retrospect, last summer’s taper tantrum seems nothing more than a blip. Not so fast. A new paper released today before the Monetary Policy Forum in New York argues that the tantrum might portend a negative response as taper continues and as the Fed moves closer to someday raising interest rates; and it might be as simple as herd mentality. We all know the markets have been feeding on free money from the Fed, and the paper says: “Stimulus is not a free lunch, and it comes with a potential for macroeconomic disruptions when the policy is lifted.”

The longer the Fed waits to exit, the more risk there is. For example, right now the Fed is boosting the economy through guidance that interest rates will stay low a long time, but officials can’t fully control how the market will perceive it when the Fed relaxes that commitment. The trade-off is “between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.”

Yellen has taken over the job of herding cats; the cats in question are her fellow Fed policymakers. Today, Federal Reserve Bank of Chicago President Charles Evans said Friday the central bank should be willing to allow inflation to go over its 2% target if that will help the economy get back on track more quickly. Meanwhile, Federal Reserve Bank of Philadelphia President Charles Plosser said:  “Most formulations of standard, simple policy rules suggest that the federal funds rate should rise very soon–if not already.”

Yesterday, Fed chair Janet Yellen broke from her prepared testimony before the Senate Banking Committee to recognize the economy has been a bit soft and, depending on data, the Fed would open to reconsidering taper, without jumping to conclusions, of course.

So, how’s the data?  In a word – weak. The Commerce Department this morning reported fourth quarter gross domestic product was worse than previously expected; revised down to a 2.4% annual growth rate from the 3.2% pace initially estimated last month, and down from the 4.1% pace of the third quarter. First quarter growth is forecast at below a 2% pace.

There were some economic headwinds in the fourth quarter: the 16-day government shutdown and the polar vortex weighed on growth but the government is open again and the weather will thaw eventually, maybe. Longer lasting moves also damped growth, including: the expiration of long term unemployment benefits, cuts to food stamps, weaker durable goods orders, and businesses working through inventory buildups in the second half, which might continue for a while. Unemployment data for December and January were surprisingly weak, and investors are focusing on the February jobs report, due next Friday, to see if the slow pace of hiring is weather-related or caused by a more fundamental downshift.

Not all data is negative. This morning the National Association of Realtors said its pending home sales index, based on contracts signed last month, rose 0.1% to 95.0 in January. The increase followed a revised 5.8% drop in December. This wasn’t a very positive report. The index fell in the West to its third lowest level since the NAR began its tab in 2001, surpassing only two months from the summer of 2007, when housing markets were beginning their free fall.

Western markets such as Las Vegas and Phoenix have witnessed some of the largest price gains as they rebound from very low levels. California markets, meanwhile, have grown much less affordable given the combination of price increases and higher interest rates. Inventories of homes for sale had been very low last year in many Western markets, but they have climbed since demand fell last fall. It’s not clear that weather can be blamed on this: the index is seasonally adjusted, and this is the West, where winters are milder. The index is now down 27% since last June, when it nearly reached a four-year high.

Also, the Thomson Reuters. University of Michigan consumer sentiment index came in at 81.6 for February, up from 81.2 in January.

And this all goes back to Fed monetary policy, and the longer the Fed stays engaged in the experimental and dangerous phase of monetary stimulus, the greater the probability of problems. One area that has already started to look bad – emerging markets. Over the past four years investors desperate for high-yielding exposure to Brazil, Mexico, Russia and Turkey, showered emerging market funds with cash. For example, Pimco’s flagship emerging market local currency fund grew to more than $12 billion from $1.5 billion. Now the inflows have turned to outflows, last year $51 billion was pulled from emerging market funds; so far this year $40 billion has flown the coup. The concern is that last summer’s taper tantrum might be followed by an emerging market bond tantrum.

The idea that a bond market tantrum, if it lasts long enough, can lead to a broader economic crisis that reaches beyond its original location is not without precedent. The debt crisis in the euro zone got its start when bond investors began selling Greek government bonds. Before long, Greece, Ireland and Portugal were getting bailed out and viability of the euro was being called into question.

As currencies like the Brazilian real and the Turkish lira have begun to wobble, the rush for the exit has become all the more hurried. Growth in these economies is already slowing down. Brazil may see economic growth below 2% this year. As investors pull money out of these funds, forcing fund managers to sell Brazilian, Mexican and Chinese bonds, interest rates will shoot up and default rates will increase in number.

And so there are concerns about another tantrum. There is precedent. Five years ago, March 9, 2009 to be precise, the stock market hit a low. Back then, the herd was heading for the exits, running for the exits, stampeding the exits. And that, of course, would have been the perfect time to buy. The Wilshire 5000, one of the broader measures of the stock market, is up about 190% over the past 5 years. Americans’ holdings of stocks have increased by about $8.8 trillion over that time.

During the same five-year period, the value of home equity has risen by about 40 percent; that’s about $3 trillion. Five years ago, at the stock market bottom, home equity, at $7.4 trillion, substantially exceeded the value of stocks owned by individuals, at $4.4 trillion. Now, stocks are about $13.2 trillion, compared with $10.4 trillion of home equity.

Five years ago, stocks looked beaten down but they roared back, much more so than home values and even more important home equity, which continued drifting down until the middle of 2012, when it finally turned upward. Home equity is still down from its peak of $12.5 trillion in 2005. At the time, stocks were $8 trillion, about 65 percent of home equity. Now, stocks are more than 125 percent of home equity.  About 5% of Americans own 60% of all individual stocks.

Household wealth for Americans still has not recovered from the downturn.  A new study rom the Ohio State University found that the mean net worth of American households in mid-2013 was still about 14 percent below the pre-recession peak in 2006. Their analysis suggested that middle-aged people took the biggest hit.

In a report last June, the Federal Reserve said that net worth of Americans, which includes the value of homes, stocks and other assets minus debts, had essentially recovered since the recession of 2007 to 2009. In fact, the Fed claimed wealth was the highest it had been in nominal terms since records began in 1945.

So maybe there is something to the idea that a herd mentality could wreak havoc in the markets, it only takes a few to start a stampede, but the downturn and the recovery didn't affect all American households the same way. Much of the recovery in net worth that has occurred since the recession can be attributed to the rise in value of financial assets, such as stocks. This tends to help those who are already wealthy. This increase has occurred because of the Federal Reserve's policy of quantitative easing, which means the Fed has bought large amounts of longer-term bonds and other financial assets, boosting their prices. Without quantitative easing, we probably would show even lower levels of household net worth. But it’s a little funny to watch Wall Street throw a tantrum with any hint of a move by the Fed. And it’s a little funny to watch the Fed pretend that their policies have saved the day.  As much as the Federal Reserve might want people to believe we have recovered from the recession, the bottom line is that we haven't.