Friday, June 20, 2014 - Wall Street’s Midsummer Night’s Dream

Wall Street’s Midsummer Night’s Dream

by Sinclair Noe

DOW + 25 = 16,947
SPX + 3 = 1962
NAS + 8 = 4368
10 YR YLD un = 2.62%
OIL + .83 = 107.26
GOLD – 5.60 = 1315.70
SILV + .12 = 20.98

Both the Dow and the S&P closed at new records, with the Dow hitting an intraday high of 16,978. For the week, the Dow was up about 1 percent, the S&P 500 was up 1.4 percent and the Nasdaq was up 1.3 percent.

Today is the last day of spring. The solstice will occur tomorrow morning at 6:51 AM Eastern time, so tomorrow is technically the first day of summer, and the longest day of the year, or at least the day with the most daylight. For the western states, we’ll have solstice at 3:51AM, so there really will be some Midsummer Night’s Dreams. The markets have been drifting in and out of fantasy and reality this week.

On Wednesday, Federal Reserve Chairwoman Janet Yellen said the Fed would keep doing what the Fed does, and all the markets heard “buy, buy, buy.” Wall Street traders opened their eyes from a Midsummer Night’s Dream and fell in love with the first trade they saw.

Yellen said inflation was just “noisy” and interest rates could stay "well below longer-run normal values at the end of 2016." Yellen nonetheless cited reasons for optimism about the economy, including resilient household spending and an improving jobs market, even as the Fed lowered some of its economic forecasts. This is a recurring theme. The Fed’s forecasts for economic growth in 2014 have resembled a downward slope. They cut their forecast on Wednesday from the range of 2.8% - 3.0% down to 2.1% -2.3%. Back at the start of 2012, the Fed thought this year, we would see 4% growth. At the start of this year, they expected 3.5% growth.

Meanwhile, the IMF is warning government officials around the world to prepare for the time when the Fed and other advanced economy central banks do raise interest rates. Not that rates will rise soon or fast, but eventually they will rise, and the IMF hopes to prolong that time, even if it risks fueling asset price bubbles. The long lead time before Fed rate increases should give governments around the world more time to get their economic houses in order. However, it also may encourage undisciplined governments to put off reforms. The IMF believes disruptive market volatility is one of the biggest risks in the years ahead.

And then there’s the question of how the Fed will actually exit QE. At the beginning of 2007 the Fed held assets totaling about $880 billion. Today, the balance sheet stands at about $4.3 trillion, including $2.4 trillion in treasuries and $1.7 trillion in mortgage backed securities. This was the Fed’s attempt to drive down actual rates on actual loans to people and businesses, with the idea that lower rates would stimulate demand. The Fed can set a target for the Fed funds rate, but that’s just a target.

Anyway, all those bond purchases worked, sort of; long term rates dropped relative to short term rates and risky obligations. The best guess is that long term interest rates dropped about 25 basis points for every $600 billion in bond purchases. And buying mortgage backed securities helped push down mortgage rates, which was helpful in putting a floor under housing prices, and likely spurred some construction, although the housing market seems to be stalled right now.

The Mortgage Bankers Association yesterday lowered its forecast for combined new and existing home sales in 2014 to 5.28 million; a decline of 4.1% that would be the first annual drop in four years. The group also cut its prediction on mortgage lending volume for purchases to $595 billion, an 8.7% decrease and the first retreat in three years. The big housing rally wiped itself out because prices increased too quickly for buyers to keep up. The pool of eligible new buyers is collapsing because of stagnant incomes and lack of credit. This revealed one of the biggest problems for the Fed’s stimulus plan; they could indeed lower rates, but they couldn’t direct distribution.

Could the Fed get back to pre-crisis balance sheets? Probably not, but they can just hold the bonds to maturity. There really doesn’t seem to be any viable option, and if the Fed continues to hold those securities, it’s a safe bet they won’t be trying to push rates too high too fast. At the same time, however, the Fed reinvests billions of dollars from maturing securities, about $16 billion each month this year, to maintain the size of its holdings.

The Fed once planned to stop reinvesting, allowing its holdings to dwindle, soon after it ended the expansion of the portfolio. In 2011, the Fed said this would be its first signal that it was winding down the stimulus campaign. But there is growing support among Fed officials to preserve the portfolio’s size instead.

Fed officials generally argue that the effect of bond buying on the economy is determined by the Fed’s total holdings, not its monthly purchases. In this view, reinvestment would preserve the effect of the stimulus campaign. Not everyone agrees with this assessment; some people believe the flow of funds is more important than the size of the balance sheet. The Fed in recent years has almost completely replaced its inventory of short-term government debt with longer-term securities that do not begin to mature until 2016.

And the composition of the balance sheet means that the Fed will have a whole bunch of paper maturing in early 2016. What they do then will be important. Reinvesting will have a fairly significant jolt for the economy. Many in the Fed have come to accept the bond holdings as a fact of life. In 2011, when the Fed first described its exit plans officials believed that reducing the Fed’s bond holdings was a necessary step to maintain control of inflation. Maybe that’s why Yellen can dismiss inflation as being nothing more than noise. So, even as the Fed reduces purchases, the overall balance sheet remains large, and reinvestments will be significant, and their feeling is that raising the target on interest rates will only provide flexibility with monetary policy.

It all sounds good on paper, but I still think the process will be a bit painful, with unintended consequences.

Let’s get you up to date on the situation in Iraq. Ayatollah Ali al-Sistani, an Iraq cleric considered one of Shia Islam's leading voices, has called for creation of new government that avoids past mistakes; so it looks like prime Minister Maliki is in trouble. Sistani called for national unity. The Pentagon says it has seen evidence of "small numbers" of Iranian troops in Iraq but no sign of a major deployment by Tehran.

Obama said yesterday he was prepared to send up to 300 military advisers to help the Iraqi security forces. The special forces troops will work in teams of around 12 and be based mainly at the headquarters of the Iraqi military, with some deployed to individual brigades. The Pentagon said today that the first couple of teams will be made up US troops already in Iraq at the embassy but that as of now no additional units had been sent.

UN Secretary General Ban Ki-moon has effectively endorsed Barack Obama's decision to hold off from ordering air strikes in Iraq, saying that any such action would likely be futile or could even backfire: "Military strikes against ISIS might have little lasting effect or even be counter-productive if there is no movement towards inclusive government in Iraq."

The oil refinery in Baiji, in the north of Iraq, has reportedly fallen to the ISIS rebels. And fighting continues, with most of the battles being won by the rebels. If you are still unclear about the events on the ground in Iraq, you are not alone. According to a Newsweek report, US intelligence has lost virtually all its local assets to be left effectively blind in the country:

“The “surprising” collapse of the Iraqi army and the defection of key Sunni tribal leaders to al-Qaeda-inspired insurgents has largely stripped the CIA of spies in … country. As a result, according to a US intelligence official, the CIA is mostly relying on “technical means”—electronic intercepts of all kinds—and the support of friendly regional secret services, like Jordan’s, to monitor the rapidly deteriorating situation.

Oil prices have inched up but not as much as some feared they would, considering that Iraq is the second largest producer in OPEC. If its supply was completely disrupted, it would take all of the world’s surplus production capacity to replace it.

Gasoline prices typically fall in the weeks following Memorial Day, after supplies increase enough to fill up the cars of the nation's vacationers as summer approaches. This year, drivers are paying more. The national average price of $3.67 a gallon is the highest price for this time of year since 2008, the year gasoline hit its all-time high.