Friday, June 14, 2013 - Slip Sliding Along

Slip Sliding Along

by Sinclair Noe

DOW – 105 = 15,070
SPX – 9 = 1626
NAS – 21 = 3423
10 YR YLD - .05 = 2.13%
OIL + 1.20 = 97.89
GOLD + 5.80 = 1392.50
SILV + .23 = 22.18

You will recall that in the final week of May, I told you we had hit the sell signal for the “Sell in May” strategy. You're welcome. Even a blind pig finds an acorn once in a while.

For the week, the Dow fell 1.2 percent, the S&P 500 lost 1 percent, and the Nasdaq slid 1.3 percent. All three US stock indexes ended Friday's session with their third week of losses out of the past four.

Oil struck a nine-month high. Oil has been trading in a tight range between $90 and $97 for more than a month, and it was just a matter of time till it made some sort of move; it was a breakout. This appears to be a war premium, what with concerns about US intervention in Syria. Syria is not a key oil supplier, but the region is.

The University of Michigan and Thomson Reuters’s consumer-sentiment index fell to a preliminary June reading of 82.7 from a final May reading of 84.5. Aside from its interest as an economic indicator, the sentiment data grabbed headlines this week with reports that Thomson Reuters gives data to select subscribers early. People are gloomy. We didn't need a early indicator from Rueters for that. The sentiment report is another nail in the coffin of the Federal Reserve tapering quantitative easing in the near term

The International Monetary Fund has issued its annual economic check-up and forecast for the US. the IMF forecast economic growth would be a sluggish 1.9 percent this year. The IMF estimates growth would be as much as 1.75 percentage points higher if not for a rush to cut the government's budget deficit.

The IMF cut its outlook for economic growth in 2014 to 2.7 percent, below its 3 percent forecast published in April. The Fund said in April it still assumed the deep government spending cuts would be repealed, but it had now dropped that assumption.

Now, they are merely urging the repeal of government spending cuts. The IMF report said: The deficit reduction in 2013 has been excessively rapid and ill-designed. These cuts should be replaced with a back-loaded mix of entitlement savings and new revenues. The IMF warned cuts to education, science and infrastructure spending could reduce potential growth. They also suggest the Federal Reserve should put off tapering, but they should try to figure out some sort of exit from QE for later down the road.

Next week the Federal Reserve FOMC will meet to figure out monetary policy. We'll parse the statement for any tell-tale whatever. While the Federal Reserve's QE to infinity and beyond has not been successful, or at least not as successful as hoped, it would be very bad indeed if the Fed were to seriously talk about taking it away. Just talking about hiking rates is almost like hiking rates, and higher rates will be a damper on economic growth and might even have a few other undesirable consequences.

Anyone remotely attentive to interest rates has probably refinanced, maybe more than once. Refi's are not a strong source of stimulus, but they do add money in consumers' pockets. So, we could expect a slight hit to consumer spending.

Further, rate increases would have an unpleasant repercussion on the Euro-zone. Government bonds have recently taken a hit around the world, now that investors are preparing for the possible end of central banks’ boundless economic stimulus. And those bonds of the weakest euro-zone countries have shown some of the biggest drops. Greek, Spanish, and Italian bonds have all jumped in the past few weeks. The spread, or the amount of additional yield investors demand, above that paid by benchmark Germany, has also risen over the past month or so.

The Japanese stock market plunged 6.4 percent Thursday. The sell-off, part of a 21 percent fall over the past three weeks, was only the most visible sign of the growing volatility in global stock, bond, and currency markets, rooted in fears that any letup in asset purchases by the Fed could trigger a global financial collapse. Fears that the Fed would draw down its quantitative easing program has also caused emerging market currencies to plunge in value. Over the past three months, the Brazilian real has fallen 8 percent against the dollar, the Indian rupee has fallen 6.8 percent, and the Australian dollar has fallen 7.7 percent.

Yesterday, the World Bank cut its growth estimate for the Chinese economy in 2013 to 7.7 percent, down from 8.4 percent, and warned of the potential for a “sharp” slowdown of the Chinese economy. The report noted the “possibility that high investment rates prove unsustainable, provoking a disorderly unwinding and sharp economic slowdown.”

Earlier this month, HSBC said that its index of manufacturing activity in China fell to 49.2 in May, the lowest level in eight months, and significantly lower than the reading of 50 that indicates the point between contraction and expansion.

And then, any scaling back or tapering off of bond and mortgage purchases would have to find alternate buyers in the bond market. They don't exist. The banks won't step in. The FDIC has already warned that higher rates would have serious consequences for US banks; the FDIC was so alarmed they begged banks to start scrutinizing their balance sheets in readiness for the day. Low rates have caused a margin squeeze for banks; they can usually pull out a little bigger profit margin when rates are higher, but the low rates have also pushed many banks to do what typical investors do – chase yield to boost earnings; and that could potentially create big losses if rates rise quickly. If you'd like an example, just refer back in 1994 when Greenspan hiked rates without so much as a “thank you, please”.

If the Fed really wants to see a bond bubble pop; they can just keep talking about taper. And the stock market in the US has been floating on QE gases. US stocks have more than doubled since their low point in early 2009. Yet since 2010, the US economy has created an average of only 162,000 jobs per month, lower even than the 166,000 average monthly growth rate of the US working-age population.

The only thing sustaining the dizzying rise in stock values, amid a disastrous real economic situation, is the vast infusion of cash into financial markets by central banks, coupled with global austerity programs that have drastically slashed wages and swelled corporate profits.

Last month, Gillian Tett wrote in the Financial Times, “While the flood of central bank liquidity is enabling the system to absorb small shocks, it is also masking a host of internal contradictions and fragilities that could surface if a shock hits. Or… precisely because central banks are trying to pursue stability at all costs, the potential for a future violent instability is rising apace; ‘tail risk,’ as statisticians say, is growing.”

Put more plainly, Tett is warning that even as the vast expansion of credit by central banks has partially masked the deepening economic contradictions in the global financial system, it has paved the way for a financial collapse on or exceeding the scale of the 2008 crash.

Maybe the Fed should have spent more time talking about the need for more fiscal stimulus and arguing against deficit scare mongering.

Also, next week, the G-8 is meeting in Northern Ireland, a little place known as Potemkin Village. They will discuss tax evasion. Part of the difficulty with addressing tax evasion is that so much of it is legal, and what isn't legal is subject to revisions by big corporations with powerful lobbyists. Take for example the big companies aligned the the Campaign to Fix the Debt. They're trying to get the politicians to fix the debt, or at least to lower their tax debt, through something known as a territorial tax system, which basically involves switching to a system of paying US taxes only on what they earn domestically. Multinationals are now taxed on profits wherever they’re made; at least in theory. A switch to a territorial tax system would save companies like GE and Microsoft and Merck, somewhere in the neighborhood of $173 billion.

Fix the Debt was co-founded by former Clinton White House chief of staff Erskine Bowles and former Wyoming Sen. Alan Simpson. The idea is to stabilize and cut the debt, in part through comprehensive tax reform, or apparently to give big tax breaks to big corporations. If you can figure out how this would reduce the debt, let me know.

Weekend Reader:

Derivatives: innovation in the Era of Financial Regulation