Thursday, June 05, 2014 - The European Central Bank Has Done Something

The European Central Bank Has Done Something

by Sinclair Noe

DOW + 98 = 16,836
SPX + 12 = 1940
NAS + 44 = 4296
10 YR YLD - .02 = 2.58%
OIL - .18 = 102.46
GOLD + 9.60 = 1254.20
SILV + .24 = 19.04

The Dow and the S&P finished with record high closes.

We start in Europe. The European Central Bank has done something. No, I’m serious, they did something; not just talked about doing “whatever it takes”, they actually took some action; nothing terribly bold; probably not enough, but something. Specifically, the ECB cut its benchmark interest rate to 0.15% from 0.25%, and the deposit rate to minus 0.10% from zero. The rate cuts will take effect next week, on June 11. They are trying the  negative interest rate, which has never been tried on a large scale, in a bid to push down the value of the euro and encourage banks to invest excess cash rather than hoard it in central bank vaults.

The ECB will also begin offering four-year loans to banks at the benchmark interest rates, under conditions meant to ensure that lenders use the money to issue loans to businesses. The loans are designed so that they can’t just borrow the money from the ECB at 0.15% and toss it into government bonds.

Also, the ECB will start buying packages of loans, or asset-backed securities; another measure designed to push lending to small businesses; right now there aren’t enough loans in the private sector to make this a big deal; but the idea is that the banks can get cheap money, lend it out, and then sell off the loans to the ECB. It’s called the targeted longer-term refinancing operations, or T.L.T.R.O., as if the world needs another financial acronym. Also, the ECB will no longer offset the impact of its holdings of bonds bought to combat the euro zone crisis in 2010 and 2011 by simultaneously withdrawing comparable amounts of money from the financial system.

This is a scaled down version of Quantitative Easing, and a very scaled down version of Abenomics. So Draghi and the ECB stopped short of using the metaphorical bazooka of full scale QE large scale asset purchases of sovereign bonds, probably because they would have a tough time working out which country’s bonds to buy; instead the ECB will purchase private sector asset-backed securities.

The idea of negative interest rates has been tried before, but not on a continental scale; still the negative part, is just a minus 0.10%, so it probably won’t be a huge game changer. If it isn’t sinking in just yet, here’s the simplified concept. Normally, if you put $100 on deposit with the bank they might pay you a small interest rate, say 1% a year. At the end of one year, you would have $101. Negative interest rates are just the opposite; if you put $100 on deposit with the bank, you would have to pay them, and so at the end of the year, you would have $99.

The theory is that when it becomes more costly for European banks to keep money in the ECB, they will have incentive to do something else with it; lend it out to consumers or businesses, for example. Or if negative rates make it less attractive for global investors to park money in Europe, it could cause the euro to fall on currency markets, helping reverse a rise in its value that has made European exporters less competitive.

Will negative interest rates work? Not necessarily. If the banks don’t start lending, they will have to start paying the negative interest rate, and then they will likely pass the cost on to the customer. They might not call it a negative interest rate, but banks are notorious for charging fees to their clients. If, or when the banks start charging fees for deposits, or however they pass along the costs, people might start pulling their money out of the banks. People might buy something when they take their money out of the bank, or they might just put it under their mattress at home.

On a smaller scale, Denmark tried negative interest rates a couple of years ago, and nothing really changed one way or the other; the Danish krona depreciated a little but it did not lead to a noticeable increase in real interest rates or an increase in bank lending.

Still, the ECB had to try something. ECB President Mario Draghi has been talking for 2 years about doing something. Now the question is whether it will work. The Eurozone faces low inflation and even deflation in certain countries. Deflation is a much bigger problem than inflation, and much less responsive to most monetary policy. Japan has been trying to escape the effects of deflation for the better part of two decades. Central banks can pump liquidity into the markets but they have a harder time creating demand in an economy.

One of the bank’s aims is to weaken the euro, which allows exporters in the euro zone to sell their products more cheaply abroad. A weaker euro also tends to push up inflation by raising the prices of fuel and other imported goods. Markets got the message. The euro fell 0.37 percent against the dollar, to $1.355, its lowest level in four months. Of course, if the Euro currency depreciates significantly, you have to wonder if Europe’s major trading partners would just sit back and fail to respond.

Will it work? I’m guessing it won’t. “Are we finished?” Mr. Draghi asked rhetorically at one point in his news conference. “The answer is no. If need be, we aren’t finished here.” Earlier, Draghi said, “If required, we will act swiftly with further monetary policy easing.” Which sounds a lot like what he said 2 years ago: “whatever it takes.”

If it sounds like the ECB’s moves are fraught with uncertainty, you are correct. This whole monetary system, whether in Europe or Japan or China or the US, is just a big experiment.

Today, Securities and Exchange Commission Chair Mary Jo White gave a speech on the stock markets and High frequency trading and dark pools. Depending on perspective it was either a major crackdown or same old same old. Mainly she said the SEC will start the process of looking into these things, which is disappointing because the SEC is supposed to be the regulator of these things. Instead we find out the SEC is looking into developing rules targeting high-speed traders, less transparent trading venues and order-routing practices, a move designed to promote fairness for investors, shine more light on the markets and bolster stability. I knew the SEC was behind the curve on these issues, but this is just sad.

Still, I guess it’s important because it does mark the first time Chairwoman White has articulated her plan for revamping equity market structure rules since she took over at the SEC in the spring of 2013. White said she has numerous regulatory proposals in the works, including an "anti-disruptive trading" rule to rein in aggressive short-term trading by high-frequency traders during vulnerable market conditions, and a plan to force more proprietary trading shops to register with regulators and open their books for inspection.

Dark pools allow investors to execute trades anonymously and do not make trading data available until after the trade is complete, if at all. White says she wants more transparency for the dark pools, and the SEC is seriously thinking about finding out who and where these dark pools are and maybe asking them to disclose more to the public and to regulators about how they operate. Any regulations that are ultimately proposed will have to be vetted through a public comment process and approved by a majority of the SEC's five commissioners. But ultimately, Chairwoman Mary Jo White wants the SEC to actually understand how the stock markets work. And to this end the SEC seems to be all in favor of disclosure. To be fair, disclosure is the SEC's answer to most questions, but it's especially the answer to questions that the SEC doesn't especially want to talk about.

Tuesday, December 17, 2013 - The Year in Financial Review

The Year in Financial Review

by Sinclair Noe

They say you can't know where you're going if you don't know where you're coming from, so today on the Review, we'll review some of the financial milestones of 2013.

You may recall that 12 months ago, we were headed over the fiscal cliff. The fiscal cliff really started in 2001 with the Economic Growth and Tax Relief Reconciliation Act, also known as the Bush tax cuts; after various extensions, they were set to expire at the end of 2012. And they did. In the end, Congress did not approve an extension of most of the tax cuts until late on New Year’s Day. Because all the Bush tax cuts had technically expired, Republicans could say they had not violated their No New Taxes pledge. The marginal rate on incomes over $400k increased, plus cap gains, and qualified dividends for high-income taxpayers, plus some estate tax changes, and the holiday on the payroll tax ended; just to be sure everybody felt some pain.

President Obama signed the American Taxpayer Relief Act of 2012 on January 2. The ATRA is usually described as a tax increase although technically it might be a tax cut. The confusion arises because there were so many expiring provisions at the end of 2012.  ATRA could be described as either a $618 billion tax increase, relative to maintenance of all of the provisions that had been in place – that is, relative to so-called “current policy”; or a $4 trillion tax cut, relative to the actual law.

It was an inauspicious start to the new year.

Wall Street found comfort in the resolution of the fiscal cliff, and of course the never-ending flow of free money from Quantitative Easing. Equity traders partied like it was 1999. Stock funds took in some $134 billion in the first ten months of this year. The Dow Industrial Average started the new year at 13,100, and never looked back. There were a few minor pullbacks but no significant corrections; just a string of record highs for the Dow, the S&P 500, and even the Nasdaq Comp hit the highest levels in 13 years. Milk and cookies indeed.

Turns out, the stock market wasn't dead,it just needed some juice from the Fed. The Federal Reserve had a major role in propping up Wall Street. The Fed's balance sheet grew by more than $1 trillion just since the start of the year, and not stands slightly north of 25% of GDP. Overlay a chart of the Fed's balance sheet with a chart of the S&P 500; carrots and peas; Fred and Ginger.

Bond markets had been absolutely giddy with QE. The yield on the 10-year note touched 1.39% back in the summer of 2012. Heading into the summer of 2013, Ben Bernanke sent up a trial balloon that the Fed had actually thought about how they might exit QE; not that they had any plans to exit; not that there was anything in reality; just a little contemplation. The bond market freaked, and threw a taper tantrum. In the process, conservative income investors were shocked to learn that bond funds can lose value. Who knew? And that is how the 30 year bond bull died.

Meanwhile, across the Pacific, Japan had been catatonic for 2 decades until Japan's new Prime Minister Shinzo Abe somehow got a hold of the Federal Reserve's playbook; but something was lost in translation. Instead of just applying enough stimulus to prop up the banks, Abe tripled the stimulus, and kicked in fiscal reform and structural reform. He tied a sack of bricks around the yen and tossed it in deep waters. The results were predictable; a smidge of inflation replaced deflation; the Japanese economy will expand about 2% for the year, and Japanese stocks are on pace for more than a 50% gain this year.

Who knew? Certainly not Ken Rogoff and Carmen Reinhart, who unfortunately became famous for their worst work – the sarcastically titled book: “This Time Is Different”. Not exactly. Turns out there was a miscalculation with the Excel spreadsheets and there isn't a real precise line where the ratio of debt to GDP becomes malignant. Simple error by a couple of academic wonks, except their theories had served as a template for economic reforms around the globe, with less than satisfactory results. If you followed the Rogoff-Reinhart Rule, you would have tightened the belt in the face of an economic slowdown; think Greece, Spain, Portugal, and to some extent, the US. The result in the Eurozone was narrowing credit spreads and scary spikes in unemployment; that eventually forced ECB chief Mario Draghi to announce “the ECB is ready to do whatever it takes.”

The Draghi Put sounded good, except to the Germans, and even after the Rogoff-Reinhart spreadsheet blunder became clear, Draghi still hasn't used the OMT, Outright Monetary Transactions, he promised back in 2012, and Euro-austerity has lead to even higher debt to GDP ratios in the most indebted Euro nations, and the ECB and IMF have denounced austerity, but they still haven't dared to experiment as boldly as the Japanese.

Meanwhile. the BRICS, Brazil, Russia, India, China, and South Africa were clobbered. In November, the Organization for Economic Cooperation and Development, the rich world's number-crunching club, lowered its global growth forecast for 2014 by nearly half a point, to 2.7%, because of the slowdown in emerging-market economies. The European Central Bank warned: "Any sharper or more disruptive adjustment in emerging market economies needs to be closely monitored, given the potential for stronger and more persistent euro area impacts." Their fast growth compensated for the developed world's stagnation and their currency reserves funded Western debt. The thirst of emerging market consumers for goods helped tide over Western companies, while their low production costs drove global trade.

Developing economies weren't prepared for a downturn in global trade. The prospect of costlier capital, courtesy of the Fed's taper talk, dried up the flow of hot money that never seemed to find its way to Main Street but did filter to emerging markets. A disinflationary environment also clobbered commodities, and many of the emerging markets rely on natural resources. Investors withdrew from emerging market equities, debt, currencies, and everything else. According to the Commodity Futures Trading Commission, the total value of commodity index-related instruments purchased by institutional investors rose from an estimated $15 billion in 2003 to at least $200 billion by mid-2008. And then the cycle turned; 2013 marks the third year of a downturn in commodity prices. At some point, the cycle will turn again.

And through it all, the United States has emerged as the cleanest shirt in the dirty clothes hamper. The Fed's QE might not have spread the wealth; actually it just concentrated the wealth, but that's not to say it didn't have some impact. The housing market bounced back; not all the way to the highs at the peak, but it helped. Global real estate deals are now back to late 2007 levels. The world population keeps growing, and the institutional buyers can't buy everything; even though they tried. That lead to an increase in rents. If, or when rates move even higher, it will likely dampen the enthusiasm for real estate. Look for a slightly calmer market in 2014.

The high price of oil pushed drivers to switch to more fuel efficient cars. The hybrid Prius is the top-seller in California and the Tesla outsold Audi and Jaguar. GM turned a profit, and completed the terms of its bailout. The US keeps coming up with new technologies, such as 3D printing and robotics. And we've become masters at spying on the rest of the world.

The US is now in its fifth year of economic expansion and economic growth is surpassing some of the emerging markets, which is back to that cleanest shirt theory. One of the big surprises for the US economy has been energy production. Domestic crude oil production is up 18% form one year ago; up 56% from 2007; nat gas production is up 28% from 2007. Oil imports have been dropping and exports of refined petroleum products has increased.

So everything was on track for economic recovery, until the politicians in Washington decided to shut down government. Remember the fiscal cliff deal that started the year? Turns out it was just a stopgap measure, and when it came time to work out a longer-term deal, well, what can I tell you; we've got the best politicians money can buy; which is to say that Congress is a train wreck waiting to happen, and it happened in October. The 16 day shutdown came with a price tag of $24 billion, with nothing to show for it but really bad political theater.

And then that was followed by the biggest municipal bankruptcy in US history. Detroit is on the skids. The BK process is still underway, and there are implications. We have seen an unelected emergency manager take over the governance of a major city. A coup. How will it turn out? I don't know but if this is going to be a template for other struggling cities, it could get ugly.

And finally, perhaps the most important financial development came from a source we didn't even know a year ago; a modest priest from the slums of Buenos Aires; Pope Francis, the new spiritual leader of more than 1.2 billion Catholics – it is a very large contingent. The new Pope published an apostolic exhortation in late November. Pope Francis called for renewal of the Roman Catholic Church and attacked unfettered capitalism as "a new tyranny", urging global leaders to fight poverty and growing inequality. Francis went further than previous comments criticizing the global economic system, attacking the "idolatry of money" and beseeching politicians to guarantee all citizens "dignified work, education and healthcare". He also called on rich people to share their wealth. "Just as the commandment 'Thou shalt not kill' sets a clear limit in order to safeguard the value of human life, today we also have to say 'thou shalt not' to an economy of exclusion and inequality. Such an economy kills," Francis wrote in the document issued on Tuesday. "How can it be that it is not a news item when an elderly homeless person dies of exposure, but it is news when the stock market loses 2 points?"

I think this, more than anything else, has changed the financial dialogue as we head into the new year. 

Thursday, December 05, 2013 - 46664

46664

by Sinclair Noe

DOW – 68 = 15,821
SPX – 7 = 1785
NAS – 4 = 4033
10 YR YLD + .03 = 2.87%
OIL + .18 = 97.38
GOLD – 18.20 = 1226.10
SILV - .28 = 19.54

Nelson Mandela is dead. News reports say the former South African President died peacefully at his home. He was 95. Nelson Mandela will be remembered as the person who, more than any other, brought an end to apartheid, the heartless policy of “separate development” in which white, black and South Asian South Africans were obliged to live apart. It is part of his towering achievement that the very notion of racial segregation is anathema throughout the civilized world.

Yes, the stock market was down again today but the economy is doing better than you thought. Third quarter gross domestic product grew at a 3.6% pace, revised up from earlier estimates of 2.8%. Wow, sounds great, until you dig into the numbers. A large part of the revision, almost half, comes from an increase in inventories. Businesses were stocking the shelves. Were they predicting a gang-buster holiday shopping season or were they caught flat-footed by a lack of demand? We won't know with certainty until we get through the fourth quarter, but most indications are that the economy is still slogging forward, and there doesn't seem to be a need for such a large inventory buildup. We know businesses accumulated more than $116 billion in inventories in the quarter, the most since the first quarter of 1998.

Growth in consumer spending, which accounts for more than two-thirds of US economic activity, was revised down to a 1.4% rate, the lowest since the fourth quarter of 2009. That line about consumer spending is a bit misleading, and I always have to issue a caveat, because the economy is about much more than consumers, but still. Consumer spending had previously been estimated to have increased at a 1.5% pace. A sluggish start to the holiday shopping season offered another reason for caution on the economy's near-term prospects. Several big retailers reported disappointing November sales, with some relying on bargains to lure shoppers. And so, there is a strong possibility businesses will still have inventory on the shelves after the holidays, and there will be no need for new orders to replenish the stocks, and that will likely weigh down GDP growth in the fourth quarter and into the New Year.

Consumers are holding onto the purse strings. Some companies that reported sales gains had to offer more bargains to attract shoppers. The need to keep discounting, which stems from sagging consumer confidence and shoppers trained to wait for bargains, will persist through the remainder of the season. Retailers have created this expectation; just check your inbox; I'll bet you're getting more and more promotional e-mails from national chains. Why rush when there might be a better deal next week.

Meanwhile, the Commerce Department reported that after-tax corporate profits in the third quarter increased at a 2.6 percent pace in the third quarter, slowing from the prior quarter's 3.5 percent pace. So profits are still growing, quite nicely, but they are growing slower. Dividends decreased $179 billion in the third quarter, in contrast to an increase of $273 billion in the second; part of that decrease is from dividends paid by Fannie Mae to the federal government in the second quarter.

The knee jerk reaction on Wall Street was that the GDP number was stronger than estimates and Wall Street looks at good news as bad news, based upon the idea that the Fed will taper from Quantitative Easing; that speculation was enough to push treasury yields to 3-month highs, but a closer examination of the numbers shows the GDP numbers to be a little less than robust. Atlanta Federal Reserve Bank President Dennis Lockhart summed it up by saying: "I am not prepared to interpret the revised third quarter number as an indication that the economy is on a much stronger track."

Another number in the report was the price index for gross domestic purchases, which came in at 1.8%, up 0.2% from the second quarter. These measures of inflation are important because the Fed has repeatedly promised not to raise the so-called fed funds rate, now at nearly zero, until the jobless rate falls below 6.5% or inflation rises above 2.5%; those are the thresholds, rather than the targets. The Fed has targeted an inflation rate of 2%; that would be the sweet spot. And as long as inflation remains below target, that provides justification to keep the fed funds target rates in the zero range.

Why is that important? Markets are jittery about the Fed starting the process of ending some $85 billion in bond purchases each month. The purchases of Treasurys and mortgage-backed securities are meant to keep interest rates low and stimulate the economy. The tapering of bond purchases, however, is likely to trigger an increase in interest rates of all kinds and that could dampen economic growth. When the Federal Reserve first hinted during the summer that it would soon scale back, mortgage rates surged and interest rates also rose in many developing countries.

A new research report by the Cleveland Fed indicates that when the inflation rate remains low, it would be justification for the Fed to maintain its Zero Interest Rate Policy. In other words, the Fed will try a balancing act; keeping the fed funds rate lower for longer, to ease the worries of investors and let the economy more gradually acclimate to a future that at some point, might include higher interest rates.

An interesting point to ponder is that inflation remains tame, perhaps even disinflationary, even as the stock market has moved to record highs. Now you might suspect that a rising stock market, even a frothy stock market, even a bubblicious stock market might have an inflationary impact on the economy; then again, maybe not. Here we are in a stock market boom, and deflation is a greater concern, and apparently a guide for Fed policy. Go figure.

Today, the European Central Bank and the Bank of England left interest rates unchanged. Deflation is a big concern in the Eurozone. Producer price inflation (PPI) fell to -1.4% in the eurozone in October. This is how deflation becomes lodged in the price chain. Prices are sticky for a while as you approach zero inflation, but once you break through the ice into deflation things can move fast; an example would be Greece.

We seem to have a glut of things, and you know the old story about supply and demand. China's fixed capital investment over the past year has been $4 trillion; that represents an 8 fold increase in the past 10 years, and it compare with $3 trillion for the entire EU and $3 trillion for the US. China is a vast new source of supply for a saturated global economy. Meanwhile, today's data on GDP suggests US businesses are a bit saturated as well. Europe's slide towards deflation is replicating what happened in Japan in the 1990s at the onset of its lost decade.

Japan is now fighting back with a strong monetary stimulus program called Abenomics, an easy money policy after the abject failure of a tight money policy. The result of tight money was that fiscal policy had to carry the entire burden instead. Budget deficits exploded as Japan battled the slump. Public debt ballooned to 245% of GDP. ECB President Mario Draghi says the central bankers are fully aware of downside risks of protracted low inflation. The ECB has been behind the curve for most of the past three years, needlessly causing a double-dip recession that caused havoc to public finances; so I guess its no surprise they took no action today.

In other economic news, the Department of Labor released its weekly jobless claims report this morning, and these results were also better-than-expected. Seasonally-adjusted claims fell by 23,000 to 298,000, significantly beating the 320,000 claims economists had predicted. Combined with yesterday's ADP payroll report, this would seem to bode well for tomorrow's monthly jobs report, but this weekly claims report was over the Thanksgiving holiday week, and the results might be slightly distorted. Still, it was the third straight weekly drop in initial claims. Not bad.

Look for 180,000 new jobs and the unemployment rate to go from 7.3% to 7.2%.

Regulators are reportedly ready to approve a tough version of what is known as the "Volcker Rule," part of the Dodd-Frank financial-reform act, which prohibits banks from proprietary trading, which is fancy talk for "gambling with their own money." Regulators were originally planning to leave a big loophole in the Volcker Rule by letting banks do what's known as "portfolio hedging”. This is basically proprietary trading by another name, because it lets banks claim that any kind of trading they do is hedging against losses somewhere in their massive, multi-trillion-dollar portfolios.

One reason why the Volker Rule might actually have teeth is the London Whale. Remember the $6 billion loss that was, according to Jamie Dimon, a portfolio hedge? Not exactly. Bankers warn that this version of the Volcker Rule means mega-banks will not be able to protect themselves from future economic calamities, which means they have no choice but to get smaller and take fewer risks.

Sounds about right.

Thursday, November 21, 2012 - Size and Composition

Size and Composition

by Sinclair Noe

DOW + 109 = 16,009
SPX + 14 = 1795
NAS + 47 = 3969
10 YR YLD - .01 = 2.78%
OIL + 1.59 = 95.44
GOLD - .40 = 1243.40
SILV + .14 = 20.09

Intraday, the Dow industrials were higher last Friday and last Monday, but this was a record high close, and that is what we look at – the close. The reason we look at the close is largely arbitrary, and the reason we celebrate the Dow record high close as opposed to the S&P 500 record high close, is again arbitrary. The significance of a close above 16,000 is not a big deal; it's just a number. Earlier in the week the market looked at the round number and could not close above; there was a pause; then today, a move above. Test, retracement, breakout; that's bullish.

We have discussed that there is a disconnect between the markets and the broader economy. We have discussed that the trickle down effect or the wealth effect has been less than satisfying for. Still, some of that money will filter into the broader economy; and the bottom line is that it's better than a poke in the eye with a sharp stick.

At some point the Fed will taper; the easy money party will end; until then, well, enjoy the milk and cookies.

Initial claims for state unemployment benefits fell 21,000 to a seasonally adjusted 323,000. Meanwhile, prices at the wholesale level dropped 0.2%. The PPI core rate, excluding gas and food rose 0.2%; so the lesson is that we can all get lower prices if we just stop driving and eating; and, we are seeing disinflation at the wholesale and retail levels. Also this morning, the Philadelphia Federal Reserve Bank reported its business activity index fell to its lowest level since May. Wall Street's pretzel logic saw this bad economic news as a positive, indicating the Fed will continue to be accommodative. Just how long the Fed can keep pumping easy money into the stock market is the big question. Japan may serve as a playbook. Today the Bank of Japan left its massive stimulus policy, known as Abenomics, in place. So, with Japan as a guide, the Fed could do much, much more. The dollar rose to its highest against the yen in more than four months.

Today, European Central Bank President Mario Draghi said the ECB would not cut the deposit rate into negative territory. Draghi tried to dispel talk the ECB was considering charging banks to deposit cash overnight in a bid to boost economic activity. The Federal Reserve pays banks to deposit funds, and there has also been talk that they might consider not paying to get that money out of the vaults and into circulation. Draghi said the central bank did not see deflation materializing, but clearly deflation is a greater concern than inflation, and deflation may force the ECB to reach deeper into their tool belt.

It's generally accepted that central banks monetary policies implemented in response to the global financial crisis prevented a deeper recession and higher unemployment than there otherwise would have been. These measures, along with a lack of demand for credit as a result of the recession, contributed to a decline in real and nominal interest rates to ultra-low levels that have been sustained over the past five years.

A new report from the McKinsey Global Institute examines the distributional effects of these ultra-low rates. Over the past 5 years, governments in the eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion both through reduced debt-service costs and increased profits remitted from central banks.

Nonfinancial corporations benefited by $710 billion as the interest rates on debt fell, however this did not result in higher levels of investment. The impact that ultra-low interest rates have had on banks has been mixed. They have eroded the profitability of eurozone banks, resulting in a cumulative loss of net interest income of $230 billion between 2007 and 2012. But banks in the United States experienced an increase in effective net interest margins and a cumulative increase in net interest income of $150 billion. The experience of UK banks falls between these two extremes.

Meanwhile, households in these countries have lost a combined $630 billion in net interest income; that's not total losses from the economic downturn, that's just net interest income.

There are limits to central bank monetary stimulus schemes. The Federal Reserve has been buying mortgage backed securities at a rate of $40 billion per month and they now hold an estimated 26% of the total of mortgage backed securities outstanding. Each month the Fed continues buying, they increase their stake by 0.8%. Even if the Fed were to taper in March and stop all MBS purchases by the end of 2014, Fed holdings of MBS would rise to about 34% of the total MBS market.

The Fed has already distorted the housing market, and if QE continues much longer, they could corner the market. What would that look like? I'm not sure, I'm just asking. Another question is whether the asset purchases have really done the job. The Fed might want to look at buying something else. Quantitative easing can be targeted at all kinds of assets and with the Fed swallowing up the entire MBS market, maybe it's time to look elsewhere. There is probably nothing to prevent the Fed from jumping into the corporate bond market, or maybe they could start buying up municipal bonds; they could start with Detroit, Riverside, and Stockton.

Regardless of whether you agree with the idea or not, or whether you appreciate the irony or not, the point is that the Fed can not only make adjustments to the size but also the composition of its asset purchases.

Today marked a big change in the Senate. I'm still trying to figure how it will affect business and the economy but a friend asked me to speak on it today, so I'll say a few words.

Senate Majority Leader Harry Reid pulled the trigger today, deploying a parliamentary procedure dubbed the "nuclear option" to change Senate rules to pass most executive and judicial nominees by a simple majority vote. The Senate voted 52 to 48 for the move, with just three Democrats declining to go along with the rarely used maneuver.

From now until the Senate passes a new rule, executive branch nominees and judges nominated for all courts except the Supreme Court will be able to pass off the floor and take their seats on the bench with the approval of a simple majority of senators. They will no longer have to jump the hurdle of 60 votes, which has increasingly proven a barrier to confirmation during the Obama administration.

Reid opened debate in the morning by saying that it has become "so, so very obvious" that the Senate is broken and in need of rules reform. He rolled through a series of statistics intended to demonstrate that the level of obstruction under President Barack Obama outpaced any historical precedent.

Half the nominees filibustered in the history of the United States were blocked by Republicans during the Obama administration; of 23 district court nominees filibustered in U.S. history, 20 were Obama's nominees; and even judges that have broad bipartisan support have had to wait nearly 100 days longer, on average, than President George W. Bush's nominees. There has been gridlock; that's true. Changing the rules can come back to bite you at a later date; that's true, too.

I have no problem with the filibuster, at least the old fashioned filibuster. I hate the modern filibuster, where a senator just says: “I filibuster” and everything grinds to a halt. If you want a filibuster, then stand up on the Senate floor, (like when Mr. Smith Goes to Washington) talk until your voice or your bladder gives out. Read from Dr. Seuss of actually try to display intelligence. We know this is possible because every time a Senate committee calls an expert witness to testify at a hearing, we never hear the witness, just the various Senators, bloviating on without end.

And if they ever did bring back the old fashioned filibuster, the could set up a wind farm on the steps of the Capitol to capture the never-ending torrent of hot air.

Friday, November 15, 2013 - Stuck in the Monetary Tar Pit

Stuck in the Monetary Tar Pit

by Sinclair Noe

DOW + 85 = 15,961

SPX + 7 = 1798

NAS + 13 = 3985

10 YR YLD + .01 = 2.70%
OIL - .04 = 93.72
GOLD + 3.10 = 1291.40
SILV + .04 = 20.88

Record highs for the Dow and the S&P 500; with the Dow closing in on 16,000, and the S&P closing in on 1800 or maybe 2000 if you blink. The Nasdaq is nowhere near record highs but it is close to 4,000 and that's a 13 year high.

It's rare that the Attorney General discusses an active investigation, but the New York Times reports Eric Holder is talking about the currency markets and how some of the biggest banks may have rigged trading in the largest and least regulated market in the financial world. Holder said: “The manipulation we’ve seen so far may just be the tip of the iceberg. We’ve recognized that this is potentially an extremely consequential investigation.”

The investigation still seems to be in the early stages; no one has been accused of wrongdoing, yet. The DOJ apparently has at least one trader who is providing evidence, and they have gathered a whole bunch of emails, instant messages, chat-room conversations, and other documents. Nine of the largest banks in currency trading have announced they are facing inquiries. The banks placed about a dozen traders on leave pending the outcome of the inquiry. And several banks are considering limiting the ability of their traders to chat electronically.

And this all comes on the heels of the Libor rate rigging scandal, the ISDAfix rigging scandal, and hell, it just seems like everything is rigged. The currency markets may be the biggest manipulation, at more than $5 trillion daily, and affecting almost all investments that must rely on a benchmark in a currency. The market for buying and selling foreign currencies has also become a major profit center for many global banks.

Meanwhile, Moody's the credit rating agency has cut 4 major US banks' credit rating by one notch. The banks that were cut are: Morgan Stanley, Goldman Sachs, JPMorgan, and Bank of New York Mellon. Moody’s said that there was less likelihood of a widespread bailout of banks by the United States government as there was during the financial crisis five years ago and that bank debt holders would be forced to shoulder more of the losses in the future. Moody's also said it expected banks would be required by regulators in the United States to hold a higher level of capital, which was likely to result in higher recoveries for creditors in any future bank default. Maybe too big to fail could become too big to bail.

In the ongoing debate over taper or not to taper, we had some interesting developments this past week. Fed Chair nominee Janet Yellen has indicated she will continue in the tradition of Bernanke, maybe even add a little monetary stimulus to the pot of QE, and although she would like to exit QE, she doesn't seem to be actively looking for the door.

Meanwhile, if we look at the targets proscribed for exiting QE, we're nowhere near an exit. Last week the unemployment rate inched up to 7.3%; of course, that data was a distorted by the government shutdown and we may need another month or two to smooth out the data. Meanwhile, a data point that hasn't received much attention is the PCE price index, which is at 0.9%, well short of the Fed's inflation target of 2%, and well short of the stated upper limit of 2.5% which might nudge the Fed to taper.

There just isn't much inflation. That doesn't mean there is no inflation, just that the threat of deflation is a greater concern than the threat of high or even hyperinflation. The core rate, excluding food and energy prices is 1.2%, which means that food and energy prices are low or dropping; good news for people who drive or eat food. And health care prices were only up at a 1.1% annual rate in the third quarter; I'm guessing that number could move higher in the fourth quarter. And the Fed has indicated that even if the unemployment rate falls down to 6.5 percent, they might be in no rush to tighten policy if inflation remains too low.

And inflation has been falling in Europe. In France inflation is at 0.6%; in Germany 1.2%, in Spain 1.3%, in Italy 0.8%, in Britain 2.2%, and for the entire Eurozone consumer prices rose just 0.7% in the year through July. The only place inflation isn't declining is Japan, where it is holding steady, and Japanese policymakers are thankful for that. Of course Japan has been involved in an experiment known as Abenomics, which is roughly triple the size and scope of QE on a per capita basis. Abenomics has been a big boom for Japanese stocks, and seems to be at least enough to put brakes on the descent into the deflationary death spiral of the past 20 years.

Let it serve as a reminder that deflation is perhaps more scary than inflation, and Abenomics serves as a playbook for how much ammo is required to fight deflation.

Central banks are finding it’s easier to push up stock and home prices than it is to prevent inflation from falling short of their targets.The greater danger comes when disinflation turns into deflation, which leads households to delay purchases in anticipation of even lower prices and companies to postpone investment and hiring as demand for their products dries up. The Fed and their central bank buddies around the globe are trying to avert the deflationary danger by pumping up their economies with lower interest rates and monetary stimulus. They have bet the run-up in stock and home prices they’ve engineered would boost consumer and corporate confidence and spur faster growth and higher inflation. Now they’re having to maintain or intensify their aid, running the risk those efforts do more harm than good by boosting equity and property prices to unsustainable levels. The danger is that someone actually looks at asset prices and says, “hmm, seems a bit steep.” Party over.

One of the overlooked aspects of inflation is the velocity of money. Right now, in the US, money is knee deep in a tar pit. The velocity of money is how fast a dollar changes hands and is circulated through the economy. Right now it stands at 1.58, the lowest rate of velocity in 60 years, below average, and down from 2.2 just 16 years ago.

All the central bank easy money lacks punch because the pipes that carry the cash to the rest of the economy are clogged. And that means the Fed's policies have not had the desired effect of creating a robust economy. So, the more important question is not whether the Fed will continue with QE, but what can they do to unclog the pipes; and if they can't do that, what tools do they have to bypass the process.

Bernanke has expressed his exasperation with the lack of fiscal policy, and Yellen made similar overtures this week. What we haven't heard is that there are some things the Fed could do to provide more direct stimulus (and it all goes back to increasing demand). And until such time as money starts to move again, there is little immediate risk of inflationary pressures.

Wednesday, November 13, 2013 - Cues for Yellen from Abe

Cues for Yellen from Abe

by Sinclair Noe

DOW + 70 = 15821
SPX + 14 = 1782
NAS + 45 = 3965
10 YR YLD - .07 = 2.70%
OIL + .84 = 93.88
GOLD + 16.10 = 1283.30
SILV - .09 = 20.71

Record high close for the Dow Jones Industrial Average. Record high close for the S&P 500 Index.

Janet Yellen starts her confirmation process tomorrow. Yesterday, a couple of Fed presidents, Dennis Lockhart of the Atlanta Fed, and and Minneapolis Fed President Narayana Kocherlakota both suggested that the current state of the economy still warrants aggressive monetary policy action.

Yellen is well known for her meticulous preparation, but it will be interesting to see how she handles questions from politicians looking for cheap shots and easy points. Political theatrics aside, Yellen is highly qualified with a very solid academic foundation, extensive policy experience, sound judgment over many years and the most effective researcher at the Fed. Her policy moves will likely be incremental and well communicated. Markets can look to a continuation of the Fed's current policy stance for now. When the time for taper comes, as it inevitably will, the central bank would partially compensate through more aggressive forward policy guidance.

None of that means much of a change and no guarantee the Fed can do much more than it is doing to help the economy break out of the doldrums of the past few years. Of course the Fed could do much more; adding $4 trillion to their balance sheet hasn't been enough to get the economy to escape velocity. There are all sorts of clever untried economic experiments that hold great promise, and then there are the tried economic experiments underway right now.

The S&P 500 has just hit a record high; it's up about 25% year to date. Very impressive, right? Ehh. The Nikkei 225 in Japan is up about 65% YTD. The yen has been devalued by about one-third. The Bank of Japan is printing more money than the Fed. Japanese companies have more cash and less debt than their American or European counterparts. Japanese manufacturing is making a comeback. And the third-largest economy in the world has rather suddenly switched from being a drag on global GDP to being one of the most potent players, and a significant net contributor to global growth. 

It's called Abenomics, after the Prime Minister Shinzo Abe, and the idea is kind of like the Fed's Quantitative Easing scheme, on steroids. And it looks like it's working, for now. Will it work in two years, five years, ten years? Who knows; but 20 years ago Japan tried to keep the yen strong, and avoid debt, and the Japanese economy was stuck and that went on for 20 years.

One of the consequences of the BoJ’s policy shift has been to weaken the yen and boost the dollar. In recent years, dollar strength has been associated with soft commodity prices and weak pricing power in the traded goods sector. That has hurt emerging markets with their high exposure to commodities and global supply chains.

In short, the initial impact of Abenomics has been to export deflation to the rest of the world. This can also be seen in the lower-than-expected inflation rates in the US and eurozone. These are the unintended consequences of the BoJ’s actions. You may not want to invest in Japan, but you do have to understand that it matters enormously whether Abenomics succeeds or fails.

Last week the ECB cut rates, and now they're indicating they still have room to move Euro interest rates even lower. And the latest edict from the Euro Commission tells the bigger Euro economies to help support the entire union: “By virtue of their size in the European economy, Germany and France have a special responsibility to contribute to the recovery in the rest of the euro area.” Over all, the European Union has shrunk its average budget deficit by around half since a peak of almost 7 percent of gross domestic product in 2009 and has “created room” for a reduced emphasis on austerity, according to a report issued by the commission. It's more of a warning than an edict, but it seems to indicate the Eurozone is growing weary of austerity.

Yellen's testimony isn't until tomorrow, but this afternoon we got a look at the text of her prepared opening remarks; an advance copy. Yellen says the Fed has has "more work to do" to help an economy and labor market that are still underperforming. Her prepared remarks also say: "I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy." Yellen said the economy and labor market were performing "far short" of their potential, while price pressures remained muted. "Inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time." 

Nothing radical from Yellen.

About 106,000 people in the U.S. signed up for private health insurance through Obamacare last month, and 396,261 for Medicaid plans, according to data today that puts the U.S. government well behind its enrollment goals. While the government had an early target of about 800,000 sign-ups in private plans for the first two months, it has scaled back expectations as delays and software flaws plagued the online federal exchange. Only 26,794 sign-ups for private plans were through the federal marketplace serving 36 states.

While enrollment in private plans barely broke the 100,000 mark, state and federal exchanges received 846,000 applications in October, covering 1.5 million people, suggesting a large population in the pipeline if the government can get the website fixed. About 275,000 people who tried and failed to sign up for health plans are being asked this week to return to the website as the software flaws that initially shut them out are being corrected. Additional people who weren’t able to complete applications on the insurance exchange will be solicited later. The enrollment numbers include people who have already paid their first month’s premium and those who have only selected a plan without paying for it.

Last week, the U.S. Department of Agriculture released its annual survey of rural America, which puts the divergence in stark relief. Non-metropolitan areas experienced their first recorded period of population loss, and a decline in the labor force participation rate pushed unemployment down slightly (though the jobless rate surpassed the urban unemployment rate earlier this year). In other words, the cities slickers are doing better economically than their country cousins.

The Department of Agriculture has a whole division devoted to rural issues, which is aimed at fixing the jobs problem through initiatives such as farming cooperatives and infrastructure development. But the long-term problem might be more structural in nature, as the USDA suggests in its finding that suburbanization is slowing down:

The housing mortgage crisis slowed suburban development and contributed to an historic shift within metro regions, with outlying metro counties now growing at a slower rate than central counties. Similarly, nonmetro counties adjacent to metro areas that had been growing rapidly from suburban development for decades declined in population for the first time as a group during 2010-12. This period may simply be an interruption in suburbanization or it could turn out to be the end of a major demographic regime.

Of course, not all cities have been enjoying a robust economic recovery; some are better than others, and some just stink.

Friday, October 18, 2013 - Biscuits on the Dark Side of the Moon

Biscuits on the Dark Side of the Moon

by Sinclair Noe

DOW + 28 = 15,399
SPX + 11 = 1744
NAS + 51 = 3914
10 YR YLD un = 2.59%
OIL + .28 = 101.15
GOLD – 2.70 = 1318.40
SILV + .07 = 22.06

There will be a lunar eclipse a little later this hour. In the West we won't see it, but you can phone your friends in the East. Maybe it explains something.

The S&P 500 index hit another all time record close.

Tobias Levkovich is the chief US equity strategist for Citigroup, and he may have had the best analysis of post-deal state of the markets: “Kicking the proverbial can down the street does not address the long-term fiscal imbalances. The twin decisions of a taper timing push out and the discord in Washington being swept under the rug until January and February roll in could keep P/E multiples more compressed as equity risk premiums stay elevated. Investors typically do not like uncertainty and it is hard to determine how these recent almost non-decisions can be seen as reinvigorating confidence aside from some relief that an imminent likely disaster has been avoided. Nonetheless, one cannot respectably believe that things truly have turned for the better as opposed to averting the worst. The long-term growth of non-discretionary government spending can still prove to be an overwhelming liability and it has not been the primary focus for legislators.”

Larry Summers will not be the next Federal Reserve Chairman, and maybe that gives him a little more time to reflect. In an interview with Charlie Rose, Summers addressed the core problem with the recent and upcoming budget battles: “ I don't know why the obsession should be with entitlements, like the test of a country is did we scale back entitlements? No, the test of the country is did we have a stronger economy for our children than we had for ourselves. That's what is in doubt and that's what we should be focusing on.”

The Iowa Electronic Markets is the only sportsbook in America allowed to bet on US elections. Next year’s midterm elections for Congress are now a tossup between the Republicans and the Democrats. Of course the odds will change over the next year. The attention span of the average voter is …, I'm sorry, what was that?

A Time magazine article published today suggests that Texas Senator Ted Cruz, leader of the conservative effort to tie a curtailment of Obamacare to funding the government, is coming under scrutiny for failing to disclose ties to a Caribbean-based private equity fund; a possible violation of ethics rules. Cruz told Time that the omission was inadvertent and that he is in the process of making corrections to his Senate financial disclosure form.

The government shutdown started on October 1^st; since then the top performing asset classes have been equities, specifically the stock markets in Japan, Spain, the US, and Italy. And of course, Google, which has now become an asset class all its own.

Google joined the $1,000 per share club today, following a better than expected earnings report last night. Google went public in 2004 at $85 a share. Google reported earnings of $10.74 per share, well ahead of consensus estimates of $10.34.

In other earnings news, both General Electric and Morgan Stanley topped Wall Street expectations for the third quarter. GE shares gained 3.6% and Morgan Stanley rose 2.6%.

Home price gains are slowing after a strong bounce off the bottom, potentially marking a new phase for the housing recovery. According to a report from Zillow, home values aren't rising as fast as they were and even dipped in a few hot markets in September. More homes are coming on the market, and Realtors report less competition among buyers.

A new report from PriceCoopersWaterhouse says funding for US startups rose in the third quarter from year-ago levels, as venture capitalists poured money into a growing number of fledging software companies. Total investments in startups rose 17% to $7.7 billion from $6.6 billion in the July-September quarter of 2012. The number of deals rose 7% to 1,005 from 937. The software industry pulled down the largest chunk of funding, nearly $3.6 billion.

The dollar fell to eight-and-a-half-month lows against the euro; down around 1 percent on the week. The Chinese economy grew at an annual rate of 7.8% in the third quarter, accelerating from the second quarter's 7.5% increase.

The 11th-hour agreement to raise the limit on US government borrowing and end a 16-day government shutdown also averted a default on Treasury bonds that had threatened the global financial system, and exposed the vulnerabilities of the economic revival plans of other countries, especially Japan and China. Perhaps no two economies outside the United States have more at stake in Washington's recurring drama than Japan and China. Not only are they the second- and third-largest economies, but they lend Washington more money than any other single nation. Both nations have adopted policies to revitalize their own economies that to some extent rely on the improving economic appetite, stable currency and increasing indebtedness of the US.

There are no bond markets large enough to give China and Japan an alternative to U.S. Treasuries for the dollars they accumulate selling exports. So the prospect of another U.S. default drama next year is likely to lend new urgency to China's preferred solution: conducting less trade in dollars and more in renminbi.

Very Serious People are warning that China might lose confidence in America and start dumping our bonds. That might not be such a bad thing. China selling our bonds wouldn’t drive up short-term interest rates, which are set by the Fed. It’s not clear why it would drive up long-term rates, either, since these mainly reflect expected short-term rates. And even if Chinese sales somehow put a squeeze on longer maturities, the Fed could just engage in more quantitative easing and buy those bonds up. China could, possibly, depress the value of the dollar. But that would be good for America; a boon for American exporters.

And a US default would be very bad indeed for Japan, which is attempting to revive domestic consumption and investment, in part, by weakening the yen as part of the policy known as Abenomics. A US default would likely prompt investors to buy yen.

Bottom line is that there will be more talk about an alternative to the dollar as a reserve currency, but there is no place to run. At least not at this time.

The Murdoch Street Journal reports JPMorgan Chase has reached a tentative $4 billion deal with the Federal Housing Finance Agency to settle claims that the bank misled government-sponsored mortgage agencies about the quality of mortgages it sold to them during the housing boom. The deal is for less than the $6 billion the agency initially sought.

HSBC Group just lost, again; this time a $2.46 billion judgment in a long-running securities fraud lawsuit. The shareholder lawsuit alleged that Household International, now known as the HSBC Finance Corporation, misled investors about its lending practices, the quality of its loans and its accounting between 1999 and 2002. The lawsuit has wound its way through United States courts for 11 years and has been regularly noted in HSBC’s corporate filings. A federal jury in 2009 in Chicago found partially in favor of the shareholders, but HSBC and the other defendants have repeatedly challenged that verdict. Yesterday, the $2.46 billion dollar decision was announced in Federal District Court in Chicago. HSBC says it will appeal.

How much does a hamburger on the Dollar Menu cost?

Wrong, it costs much more. The fast-food industry costs US taxpayers about $7 billion a year, according to a report released this week. Researchers at the University of California at Berkeley and the University of Illinois said this subsidy comes about because 52% of fast-food workers are paid so poorly that they must rely on public assistance programs such as Medicaid and earned income tax credits. The fast food industry earns profits, pays dividends to shareholders, and pretty good wages to CEO's, but they stick the low wage costs on taxpayers, whether you eat their food or not.

Taco Bell and McDonald's are welfare queens. There is no free lunch. There is not even, really, a Dollar Menu.

 In 1965, CEOs at big companies earned, on average, about twenty times as much as their typical employee. These days, CEOs earn about two hundred and seventy times as much. That huge gap between the top and the middle is the result of a boom in executive compensation, which rose eight hundred and seventy-six per cent between 1978 and 2011. Last month, the SEC unveiled a rule to require companies to disclose the ratio of the CEOs pay to that of the median worker. The drive for transparency has actually helped fuel the spiralling salaries. For one thing, it gives executives a good idea of how much they can get away with asking for. The idea behind transparency is that full disclosure would embarrass companies enough to restrain executive pay, but the reality is that people who can ask to be paid a hundred million dollars are beyond embarrassment. A more crucial reason, though, has to do with the way boards of directors set salaries.

Boards tend to be comprised of members from peer companies that are bigger and tend to pay their own CEOs more. Also, boards tend to look at the CEO salaries of peer group firms and then peg their CEO's pay to the fiftieth, or seventy-fifth, or ninetieth percentile of the peer group; never lower. With all the companies following the same protocol, salaries ratchet higher, regardless of performance. It's known as the Lake Wobegone effect, where all the CEOs are above average.

Today's program has been brought to you in part by Powdermilk Biscuits. Heavens they're tasty and expeditious.