Monday, November 11, 2013 - Fed Stuck As Other Central Banks Race to Bottom

Fed Stuck As Other Central Banks Race to Bottom

by Sinclair Noe

DOW + 21 = 15,783
SPX + 1 = 1771
NAS + 0.56 = 3919
OIL + .54 = 95.14
GOLD – 7.60 = 1282.90
SILV - .16 = 21.45

A fairly boring day on Wall Street ended with the major averages in positive territory and that was good enough for record highs on the Dow Industrial. The bond market was closed because of the Veterans Day holiday. Volume on the S&P 500 was down by about 23%. Of the 447 S&P 500 companies that have released third-quarter profits so far, 75% have beaten analysts’ forecasts. Earnings per share for the companies that have reported, increased 4.7% in the third quarter. All fairly good news.

This will be a relatively light news week. Key economic reports include Thursday’s Sep trade deficit (expected to widen to -$39.0 from -$38.8 in Aug) and Friday’s Oct industrial production report (expected -0.1%). The Treasury this week will conduct its $70 billion quarterly refunding operation. There are speaking engagements by Minneapolis Fed President Kocherlakota and Atlanta Fed President Lockhart on Tuesday and by Philadelphia Fed President Plosser on Thursday. Fed Chairman Bernanke will hold a town hall meeting with educators on Wednesday in Washington D.C.

One quick point that I didn't get to last week, last Thursday, during a speech, New York Fed president William Dudley said that some of America’s largest financial institutions appear to lack respect for the law. Dudley suggested that regulators may be stymied by "cultural" issues that have negatively affected the nation's biggest banks, saying: “Collectively, these enhancements to our current regime may not solve another important problem evident within some large financial institutions -- the apparent lack of respect for law, regulation and the public trust. There is evidence of deep-seated cultural and ethical failures at many large financial institutions,” he continued. “Whether this is due to size and complexity, bad incentives, or some other issues is difficult to judge, but it is another critical problem that needs to be addressed.”

Dudley linked accountability and enforcement to “too big to fail,” arguing that ending the perception that some banks will forever be rescued from failure will “encourage the needed cultural shift necessary to restore public trust in the industry.” and he added, “Tough enforcement and high penalties will certainly help focus management’s attention on this issue.”

Last week the European Central Bank cut interest rates; part of a global race among central banks to push their respective currencies lower. The only central bank not participating in the race to the bottom is the Fed, which is still debating taper.

It's still a good bet that the Fed won't taper asset purchases until March or so, even after Friday's stronger than expected jobs report, which wasn't quite as strong as the numbers suggest. Fed policy makers will probably need to see more data to confirm the strength of the economy because the jobs report might have some distortions in the data due to the government shutdown in October. There’s been a correlation between rising share prices and Fed's Zero Interest Rate Policy and the QE program. People legitimately are wondering if and when the Fed begins the tapering, because the markets seem to mirror the Fed's balance sheet, which has swelled with QE purchases.

With taper on hold, investors are feeling fairly bullish. The most recent reading of the Investors Intelligence gauge of adviser sentiment showed that 55.2% of respondents were bullish and just 15.6% bearish, tying the highest difference between the two this year. The last time the gap was bigger was April 8, 2011, which preceded the sharpest stock-market correction of the current bull market. Bullish sentiment is considered a contrarian indicator because if everyone is bullish, who's left to buy more shares?

The big story from the Fed this week involves the confirmation hearings for Fed vice-chair Janet Yellen to replace Ben Bernanke. She will likely face at least some opposition, and the reason for the criticism is likely to be inflation. Which is kind of strange because ZIRP and QE have not sparked inflation, despite protestations to the contrary. Low interest rates are generally a sign that money has been tight, not that it's easy. You can't tell how tight or loose monetary policy is just from how high or low interest rates are. The only way to tell is to look at how the economy is doing. Take the 1970s. Interest rates were actually pretty high, but there was still an inflationary spiral—was that "tight" money? Or take the 1930s. Interest rates were zero, but the economy was still in a deflationary death spiral—was that "loose" money? The answers are no and no. Money tends to be tight when inflation is low and money tends to be loose when inflation is high.

Of course, one reason the Fed's money printing policy hasn't produced inflationary consequences is because it has been highly concentrated on printing money because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed's ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees.

So, the Fed is currently stuck between a rock and a hard spot; their policy has managed to inflate asset prices (the Dow hit another record high today) and if the Fed wants to target asset prices, they would tighten monetary policy to halt an emerging bubble, meanwhile, if they look at broader economic conditions they would have a bias toward monetary easing. The simple truth is that monetary policy has diminishing impact, largely because the idea of trickle down and the wealth effect is a bunch of hokum.

So, the Fed will have a difficult dilemma as asset prices move higher, we might reasonably expect lower returns for risk taking, and the spread between prospective returns for high risk assets and lower risk assets will shrink, further diminishing the impact of monetary policy. At some point the Fed will have to make a decision about whether they want to keep throwing money at Wall Street without any positives for the broader economy. This should be the line of questioning for the new Fed head nominee, instead I suspect the politicians will focus on inflation and other non-existent phantasms.

On the 11^th hour of the 11^th day of the 11^th month, 95 years ago, there was peace; Armistice Day marked the end of the Great War, the war to end all wars, or what we now call the First World War. Others followed of course, but up to that point the Great War had been the most destructive war in history, with a total death toll estimated at about 20 million, and millions more had been wounded. And for many years after the Great War, everything would stop at 11AM on the 11^th day of the 11^th month; everything would stop for 2 minutes of silence and prayer; traffic would pull over to the side of the road, factories would stop the assembly lines, shopkeepers would stop selling, customers would stop buying; widows of the fallen would weep. We don't do that anymore. There are no more veterans of World War One; they've all passed now, but we've seen plenty of other wars, and today is when we remember that without veterans there would be no America; we remember that on a day of peace.