Thrusday, January 16, 2014 - The “It Could Be Worse” Victory Lap

The “It Could Be Worse” Victory Lap

by Sinclair Noe

DOW – 64 = 16,417
SPX – 2 = 1845
NAS + 3 = 4218
10 YR YLD - .04 = 2.84%
OIL - .07 = 94.10
GOLD + .70 = 1243.70
SILV - .11 = 20.20

The number of Americans filing new claims for unemployment benefits fell for the second consecutive week last week; down 2,000 to 326,000. This might suggest that the December jobs report, which was a weak 74,000 jobs added, maybe that report was just a temporary slowdown.

In a separate report, the Philadelphia Federal Reserve Bank said its business activity index rose to 9.4 points this month from 6.4 in December. Any reading above zero indicates manufacturing expansion in the region.

In another report, the Labor Department said its Consumer Price Index increased 0.3% after being flat in November. In the 12 months to December, consumer prices accelerated 1.5%. A 3.1% increase in gasoline prices was mostly behind the spike in inflation last month. The increase in gasoline was the largest since June and followed a 1.6% fall in November. Food prices rose 0.1% for a third month. There is no wage inflation. Average hourly earnings adjusted for inflation fell 0.3% in December; and with the weakness in the labor market, there is very little chance of wage growth for quite some time.

The Fed targets 2 percent inflation, although it tracks a gauge that tends to run a bit below CPI. And outgoing Fed Chairman Ben Bernanke says inflation is not a problem, and he cited this morning’s CPI report. As for overinflated assets, Bernanke said the Fed is "extraordinarily sensitive" to that risk after the financial crisis, which began with the bursting of a massive property price bubble, but rather than to try to pop bubbles with the blunt tool of higher interest rates, Bernanke said in the Fed is using supervision, regulation and other microeconomic-type tools to be sure the threat is minimal.

Bernanke claims there is no fear of hyperinflation, and he believes the Fed has the tools to manage inflation and avoid bubbles and keep everything under control. And to hear Bernanke talk, you might not think that the past 5 years have been a big monetary experiment. And maybe they have and will continue to avoid bubbles, but if you believe that, then you also believe the markets are fairly valued right now. So, what would happen if the Fed just stopped QE tomorrow? Imagine a market where the Fed just stopped buying Treasuries and mortgage backed securities. You are likely imagining a market dropping about 20%; maybe more.

Anyway, Bernanke is taking a victory lap as part of his farewell tour, and to some extent he’s probably entitled; the extent being that this whole grand experiment could still end quite badly. But for now things are improving, even if it has been painfully slow improvement; still it could be worse; it could be Europe.

If we compare the economic recovery of the United States since the Great Recession with that of the Eurozone, the differences are striking, and instructive. The US recession officially ran form December 2007 to June 2009, while the Eurozone recession ran from January 2008 to April 2009, and then they dipped back into recession in the third quarter of 2011 and lingered for another couple of years. Now you can argue that the US is still in some form of economic malaise, what with 20 million unemployed, but the technical definition of a recession doesn’t always count things like people out of work. In the Eurozone, unemployment is at near record levels of 12.1%, while in the U.S. it is currently 6.7%. In Greece and Spain, unemployment is over 25%, and youth unemployment is approaching 60%.

How are we to explain these differences? The Federal Reserve lowered short-term interest rates to about zero in 2008 and has kept them there since. The Fed also signaled its intention to keep these interest rates at these levels for a long time. And venturing into uncharted territory, the Fed engaged in three rounds of "quantitative easing," or more than $2 trillion of money creation. Just how much the Fed policy served to stimulate the economy is questionable, but there has been some impact. The stock market and the housing market saw an injection of liquidity, and some people got very, very wealthy, and maybe a little  of that spilled over into the broader economy; maybe. At the least, it helped to avoid the double dip that befell the Eurozone.

In the Eurozone, the response was tightening and austerity, and the IMF has now admitted that austerity has led to even higher levels of debt than before, and reduced GDP growth. Now the question is why the Europeans have been so unfortunate to be subjected to much more brutal economic policy than what we have experienced in the United States. While there are many nuances, there are also some simple but deadly important reasons. Most vital is the accountability, or lack thereof, of the institutions making the decisions. In Europe you have the so-called "troika" -- the European Central Bank (ECB), the European Commission, and (more recently recruited) the IMF. These are much less accountable to Eurozone residents -- especially but not limited to those of the most victimized countries (Spain, Greece, Portugal, Ireland, and Italy) -- than even the relatively unaccountable Federal Reserve and US Congress and executive branch are to Americans.

Some examples: In all 27 countries, the IMF recommended budget tightening, with spending cuts generally favored over tax increases. In 15 countries there were recommendations on health care: 14 were to cut spending. In 22 of the 27 countries there were recommendations to cut pensions. In half the countries, the Fund also gave advice on employment protection; in all of them, the recommendation was to reduce employment protections. Reducing eligibility for disability payments or cutting unemployment compensation, raising the retirement age, and decentralizing collective bargaining were also recommended.

But perhaps even more remarkably, this evidence tells us why the ECB allowed repeated and severe financial crises in the eurozone to take their toll on the eurozone and world economy for nearly three years. Not until July of 2012 did ECB President Mario Draghi utter those famous three words -- "whatever it takes" -- which, backed up a few weeks later by the new "Outright Monetary Transactions" program, put an end to the threat of financial meltdown.

After more than 20 European governments have fallen during the prolonged crisis, the pace of the destructive budget tightening there is finally winding down: from about 1.5 percent of GDP in 2012, to 1.1 percent in 2013, to 0.35 percent in 2014. But who knows how many more years it will take to reach normal levels of employment.

This is not to say that the US recovery has been a shining example, and Bernanke should not take too many bows, but it could have been worse.

It is earnings reporting season. Goldman Sachs’ profit fell 21 percent, as revenue from fixed income trading dropped 11% after adjusting for an accounting charge. Fixed income trading revenue accounted for 48% of Goldman's total revenue back in 2009. In the fourth quarter of 2013, it was 25%.

Profit at Citigroup rose 21%, after adjusting for items, as it cut costs and released dipped into funds set aside for bad loans. Now worries. What could go wrong?

Right before Christmas the Emergency Financial Manager for Detroit negotiated a settlement to end a costly interest rate swap with two investment banks. Ending the swaps with UBS and Bank of America Corp's Merrill Lynch Capital Services for $165 million was a key component of Detroit emergency manager Kevyn Orr's plan to adjust the cash-strapped city's finances through the municipal bankruptcy process.

Detroit currently pays about $50 million a year to the banks in exchange for the swaps, which provided a steady interest rate of about 6% on a $1.4-billion pension funding deal. That equals nearly 5% of the city’s sparse general fund budget.

The $165 million deal represented a 43% discount from a previously negotiated deal for a payment of $285 million to the banks, which the bankruptcy judge said was far too generous to the banks. Today, that same bankruptcy judge said the $165 million is still too high a price to pay.

Bankruptcy Judge Steven Rhodes said the city must stop making poor financial decisions, and it’s his judicial responsibility to ensure it emerges from Chapter 9 bankruptcy as a financially sustainable municipality. 

It represented a major win for Detroit retirees, city residents, the pension funds, several European banks and a bond insurer called Ambac Assurance, which aggressively fought the settlement. Because Rhodes denied the deal, they stand to get more money from the city’s eventual bankruptcy restructuring. It represents a major loss for the investment banks. Before you celebrate, this just sets the stage for a possible legal battle.