Thursday, June 20, 2013 - Fed Fallout

Fed Fallout

by Sinclair Noe

DOW – 353 = 14,758
SPX – 40 = 1588.19
NAS – 78 = 3364
10 YR YLD + .11 = 2.42%
OIL – 3.61 = 94.70
GOLD – 73.50 = 1278.80
SILV – 1.75 = 19.70

Yesterday the Federal Reserve FOMC issued a formal statement that they were holding steady with their zero interest rate policy and their Quantitative Easing policy which involves buying up $85 billion a month in Treasuries and mortgage backed securities. Then, Chairman Bernanke held a press conference and said the Fed might scale back purchases if the economic data gets better. And while Bernanke was trying to make a very nuanced forecast with no specific call for action, what the market players heard was a threat the Fed would slash the flow of free money; the plug was being pulled on the money printing press.

Faced with the economic crisis of 2008, the Fed started creating money at a prodigious pace and giving it to the banks. Catastrophe was averted. The money flowed into the markets and financial asset prices jumped. The US equity markets have been on a 4 year bull run; housing prices have bounced back, at least a partial bounce. The money did not flow into the broader economy. Cheap money and credit, instead, lead to malinvestment. The result is that while some financial asset prices have jumped dramatically, the rest of the economy has stagnated or atrophied. The idea is that the economy did not go through its normal cycle of boom and bust; and by avoiding the catastrophe we also lost the opportunity to cleanse the malinvestment from the economy; we lost the opportunity to correct the structural deficiencies.

So, yesterday Bernanke hinted that QE might end later this year or maybe at some indefinite point in the future. The money power is so concentrated that the hint was interpreted as a threat and the threat was taken as an attack. Rarely do I say that the stock and bond markets go up or down on any given day because of some specific news story, but the past couple of days the markets dived because the Fed might take away the free money. The key question is how much malinvestment is still clogging up the economy.

The idea behind Quantitative Easing was that the free money would be spent; it would circulate through the economy; the economy would heal. There should be inflation by now; instead the free money either went down a dark hole or it has ended up in concentrated clusters. There should be a surge in employment and growing demand as workers spend their wages; instead the job growth has been anemic and the quality of jobs has been declining; the result is that demand has failed to gain traction.

Yesterday the New York Times had an article that said, “Even pessimists feel optimistic about the American economy.” And the Fed's monthly report concluded that the "downside risks" were reduced. Housing is coming back. The stock market is up. Profits are at record levels. The sequester cuts haven't sabotaged growth. Consumers feel more confidence.

Only one problem with all this. The economy can't recover if the people don't. Official unemployment has drifted down to an abysmal 7.6 percent but largely because people are dropping out of the workforce.

There are still over 20 million people in need of full time work. The employment rate -- the percentage of the population in the workforce -- hasn't budged from recession levels. At current rates, the US won't return to the pre-recession 5% unemployment rate until 2022, and even at that level, American families are losing ground.

Corporate profits are up, wages aren't. Wages are now at the lowest percent of the economy on record. The median wage hasn't budged this century. College and non-college grads are now losing ground. The good jobs that were lost are being replaced by low wage and part-time jobs. Young people are starting out behind, unemployed or underemployed at ruinous high rates. Our Gilded Age inequality is getting worse, with the top 1 percent pocketing all of the rewards of growth.

The Federal Reserve is turning out to be a one trick pony and that one trick is getting old. Maybe the Fed was fairly effective in avoiding a complete meltdown in 2008. Maybe the time has come to consider that the economic models need to be changed or at the very least adjusted. Maybe it is time for the Fed to move away from printing money and giving it to the banks. Of course, the fear is that every time the Fed pulls away the punch bowl, the financial markets shuffle to the edge of the dark hole and threaten to go over the cliff, like so many lemmings. The Fed has already "tightened" prematurely three times in the last five years, coming to regret its haste within three months on each occasion.

If the Fed is going to move forward with tapering or tightening or whatever you want to call it, it's not enough to exit QE and calm the froth in the financial markets. It may be a very good thing to flush out the excesses in the banking system; it would be great to see some reining in of the excessive risks in derivatives markets and some control over shadow banking and off-shoring of capital. But it would seem the only responsible way to flush out the malinvestment is to take some steps to provide stimulus to the broader economy. While lowering interest rates doesn't do much to stimulate demand in the real economy, raising rates will typically slow growth and might do more to choke off a recovery than the Fed has anticipated.

We need dramatic reforms to make this economy work for working people. That requires major long-term investments to rebuild the country and renovate education and training, from pre-K to affordable college, putting people to work. We need a sensible strategy for balancing our trade and reviving manufacturing, capturing the lead in the green industrial revolution that is already sweeping the world. It requires empowering workers to gain a fair share of the profits and productivity they are helping to generate, raising the minimum wage, and bringing millions of undocumented workers out of the shadows. And it requires curbing the executive compensation policies that give CEOs million dollar incentives to plunder their own companies. Tax reform that shuts down tax havens abroad and requires the wealthy to pay their fair share can cover the bill.

And we probably need some new thinking in economics. The alternative is that we stumbled along like this indefinitely. Not quite crashing, not quite recovering. Welcome to the new normal.

And what if the recovery stalls again? What if inflation fears never materialize? Can the Fed back away from QE now, only to flip the switch and turn it back on? Can they do that even if they have repeatedly shown they will cower in fear at the hint of inflation? Can they back away without having hit their targets? And if the recovery stalls, has the Fed done irreparable damage?

Meanwhile, amidst all the brouhaha over the Fed, you might not have noticed that China has taken a stand against expanding its money supply. It looks like the People's Bank of China will try to pop the credit bubble and do it fast, even if it results in short-term pain. The China strategy is to tighten before the Fed winds down QE in order to avoid two negative shocks occurring simultaneously.

The one-two punch has already hit the emerging markets, especially commodity exporters such as Brazil, South Africa and Russia that sell to China, but also tripping up Turkey, Ukraine, Hungary and others that rely on external funding. Everything is being hit indiscriminately.

Just take a look at the chart of the BRICS. The 10 year Treasury yield zipped up past 2.4%; gold has been tied to a whipping post. Asia had a nasty day of trading; the Nikkei dropped about 1.7%, although that's kind of a normal day lately; the Hang Seng dropped 2.9%. Major European markets were down hard. Copper hit a low for the year.

Protesters are expected to flood more than 100 Brazilian cities and surround two international soccer matches. After more than a week of the largest protests in over two decades, demonstrators show no signs of letting up. Though the transport fare hikes that sparked the unrest were rescinded in Brazil's two biggest cities yesterday, demonstrators by the hundreds of thousands promised to take to the streets in locales as diverse as the Amazon capital of Manaus to the prosperous southern city of Florianopolis.

The persistence of the protests reflects what has become a generalized host of complaints about high taxes, inflation, corruption and poor public services, from hospitals and schools to roads and police forces. The complaints about bus fares seems like such a mundane thing, but once you reach a certain point, whether it's bus fares in Sao Paulo or cutting down some trees in a park in Istanbul, it's a spark, and it just takes a little spark to light a fuse, and it can happen very, very fast.