Wednesday, July 16, 2014 - The Color of the Day is Beige

The Color of the Day is Beige

by Sinclair Noe

DOW + 77 = 17,138
SPX + 8 = 1981
NAS + 9 = 4425
10 YR YLD - .01 = 2.53%
OIL + 1.38 = 101.34
GOLD + 6.20 = 1300.80
SILV + .07 = 20.89

A record high close for the Dow; the 15^th record high close of the year for the Dow. The S&P 500 did not take out the old high from July 3^rd. We have a few economic reports to cover, plus Fed Chair Yellen continued testimony on Capitol Hill, and lots more.

Industrial production increased 0.2% in June to 103.9. This is 24.1% above the recession low, and 3.1% above the pre-recession peak. For the second quarter, industrial production advanced at an annual rate of 5.5%; so the quarter was good but the month of June was less than expected.

The Commerce Department reports producer prices increased by a seasonally adjusted 0.4% last month, above forecasts for a 0.2% gain, after falling 0.2% in May. Year-over-year, the producer price index rose at an annualized rate of 1.9% in June. The core rate, stripping out food and energy prices, was up 0.2%.

This afternoon, the Federal Reserve released its Beige Book, a collection of reports from the 12 Fed districts. The general consensus is that economic growth was moderate to modest. Most Districts were optimistic about the outlook for growth. Consumer spending increased in every district. Retail sales grew modestly in most districts. Auto sales, which have been on the upswing for more than a year, continued to stand out as particularly brisk support for the economy, but broader retail sales were more subdued. Labor market conditions continue to improve with all districts reporting slight to moderate employment growth. Several districts reported "some difficulty" finding staff for skilled positions, however there doesn’t seem to be any pressure on wages. Here’s a hint, if you can’t find skilled workers, try offering higher wages. The report gave a mixed appraisal of the US housing market. Conditions "varied" across the country, with some regions suffering from weak demand.

Fed Chair Janet Yellen returned to Capitol Hill to deliver her second day of Humphrey Hawkins testimony. The prepared remarks were the same as yesterday, then they open up for a Q&A. Some of the key points from today’s hearing:

Yellen said she is optimistic about the economy, “We had a very surprising negative growth in the first quarter, which is a number that in a way doesn't seem consistent with the underlining momentum in the economy and many indicators of spending and production. And I do think the economy is recovering and that growth is picking up and that we have sufficient growth to support continued improvement in the labor market."

Yellen said threats to financial stability are moderate “and not a very high level.” She again weighed in on valuations, saying: "Some things may be on the high side and there may be some pockets where we see valuations becoming very stretched but not generally. The use of leverage is not broad-based, it hasn't increased, and credit growth is not at alarming levels by any means."

Yellen did not single out specific sectors today. Yesterday she said biotech and social media looked a bit over-valued. That had some talking heads complaining; the funniest rant came from Jim Cramer, who said: “Next time, Fed Chief Yellen, it might pay to point out that there are plenty of cheap stocks out there, too. At least that way you can help us make money, not just lose it.” Maybe someone can tell Cramer the Fed is not in business to help him make stock picks, no matter how much help he needs. The Fed has been incredibly accommodative to Wall Street, and Cramer still complains. The Fed doesn’t issue a price target on Twitter. But if you read between the lines, Yellen was likely saying that there are no plans to raise the margin requirements on brokers.

There were some questions about a bill in the House that would require the Fed to follow a mathematical rule for when to raise or lower interest rates. Yellen didn’t like that idea; she said there is no magic formula for raising rates. Yellen again expressed confidence the Fed can exit when the time comes. The Fed has a variety of tools it can use to raise interest rates. In the distant future, the Fed’s balance sheet will shrink in size.

The best line from the Fed did not come from Yellen; Dallas Fed President Richard Fisher was speaking today at the University of Southern California. Fisher said ending asset purchases this fall isn’t enough; the Fed should start to taper the reinvestment of maturing securities in October. Fisher said: "Monetary policy is a bit like duck hunting. If you want to bag a mallard, you don't aim where the bird is at present, you aim ahead of its flight pattern. To me, the flight pattern of the economy is clearly toward increasing employment and inflation that will sooner than expected pierce through the tolerance level of 2%."

Meanwhile, it’s earnings reporting season. Bank of America said profit declined 43% as it spent $4 billion to cover litigation costs, including a mortgage settlement with AIG. There seems to be a trend developing in banks’ earnings reports; they are making money on investment banking and some other areas, but results are weak for mortgage originations, and they are setting aside big chunks of earnings to pay for legal settlements.

Bank of America and the Department of Justice are reportedly negotiating a mortgage securities settlement, which could cost the bank around $13 billion.

Intel was up more than 9% after a very strong earnings report after the close yesterday. Yahoo fell today following weaker than expected earnings. EBay posted lower than expected 2Q results and even though sales were up this month, EBay cut its outlook for the third quarter.

Merger and acquisition activity has been wild lately. Today’s M&A stories revolved around Rupert Murdoch’s plan to buy Time Warner for $85 a share, or about $75 billion. Time Warner says it isn’t interested in exploring a sale, but if they sell, there are other potential suitors. General Electric is in talks to sell its household appliances business; that’s a part of the company that’s been around since 1905, when they invented the electric toaster. Yesterday, the number 2 tobacco company, Reynolds American agreed to buy the number 3 tobacco company, Lorillard for $25 billion.

One of the motivating factors behind mergers lately has been something called inversion, basically merging with an overseas company to avoid corporate taxes in the US. Members of the House and Senate have made proposals to curb the inversion trend in recent months, and the president included a provision in the budget he presented to Congress this year that would have effectively banned the move. But none of these efforts have yet gained traction. Today, Treasury Secretary Jack Lew called on Congress to enact legislation to halt inversion, effective immediately and retroactive to May.  Making any new legislation retroactive through May could disrupt several megadeals that have already been struck, such as the Medtronics deal.

Global M&A volume in the first half was the highest since 2007. One of the side effects of the M&A frenzy back in 2007-2008 was the frenzy of pink slips that followed. Deals are sold to investors on the basis of “creating value” with terms like “efficiencies” and “synergies”; code words for cost cutting and mass-layoffs. Acquisitions, layoffs, and cost-cutting are the simplest things to do for a CEO, as opposed to inventing things and boosting sales organically, which is hard. Analysts love M&A, investors too, and of course the investment bankers promote it as the best thing since sliced bread, or maybe electric toasters.

Last year, Microsoft acquired Nokia’s mobile phone business and promised $600 million in cost saving and efficiencies and synergies. Now, Microsoft employees are bracing for up to 12,000 layoffs, the biggest ever for Microsoft. The layoff news will come before the company holds its post-earnings conference call after the market closes July 22.

Leaders of the five BRICS nations agreed on the structure of a $50 billion development bank by granting China its headquarters and India its first rotating presidency. The leaders also formalized the creation of a $100 billion currency exchange reserve, which member states can tap in case of balance of payment crises. Both initiatives, which require legislative approval, are designed to provide an alternative to financing from the International Monetary Fund and the World Bank, where BRICS countries have been seeking more say.

Wednesday, June 04, 2014 - An Airtight Defense

An Airtight Defense
by Sinclair Noe

DOW + 15 = 16,737
SPX + 3 = 1927 (record close)
NAS + 17 = 4251
10 YR YLD + .01 = 2.60%
OIL - .27 = 102.39
GOLD – 1.30 = 1244.60
SILV - .01 = 18.90

Eight times a year the Federal Reserve gathers economic updates from the 12 districts and publishes the information about two weeks before its FOMC meetings. The data is published in a beige folder, and that is why it is called the Beige Book, although it might actually refer to the writing style. Anyway, economic activity expanded all across the country, with most districts reporting moderate or modest growth. Consumer spending expanded across almost all districts. Tourism was another bright spot and manufacturing activity expanded across the country. Home sales were described as “mixed across the country” even as home prices continue to rise. Labor markets were described as steady. Inflation was tame, with a slight exception for higher food prices in some areas.

In other words, when the Fed meets in a couple of weeks, there won’t be any big changes in monetary policy.

The Institute for Supply Management said its services index rose to 56.3%, its highest level since August, from 55.2% in April. That’s the number and they’re sticking with it.

The US trade deficit grew to $47 billion in April, up from $44 billion in March. Exports slowed in April, down slightly to $193 billion. Imports, meanwhile, surged by nearly $3 billion to $237 billion, mainly driven by increased spending in consumer goods and cars.

A new survey from the MacArthur Foundation finds 70% of Americans still feel a housing crisis remains today and the worst is yet to come; that’s down from 77% a year ago, but still it doesn’t look like there’s much confidence in a housing recovery. Half the respondents think housing represents a good long term investment, while 43% says that’s not the case; two-thirds say it’s harder to build wealth through home ownership than 20 or 30 years ago. Over half of Americans, 52%, have had to make at least one major sacrifice in order to cover their rent or mortgage over the last three years.

In line with the survey on housing, a new poll from CNN and ORC International finds 59% of adults think the American Dream has become impossible for most to achieve, up from 54% in a poll conducted in 2006. What’s more, 63% of those surveyed believe most children in the US will grow up to be worse off than their parents. While most Americans say they’re better off than the prior generation, they also feel gains in living standards are grinding to a halt. One problem is that the survey didn’t define exactly what the American Dream is supposed to be.

ADP, the payroll processing firm, issues a monthly payroll report ahead of the Labor Department each month. The ADP report is not always an accurate predictor of the government report but it is still closely watched for any hints. ADP says the economy added 179,000 private sector jobs in May; that’s significantly below the consensus estimate of 200,000 to 215,000 jobs for the Friday jobs report.

According to the latest revisions from the Labor Department, productivity in the first quarter declined at a 3.2% annual rate, the worst in six years, as workers spent more time on the job producing fewer goods during an unusually stormy weather.

A new research study published today from the Economic Policy Institute shows a sharp disconnect in the late 1970s between the overall productivity of the US economy and wage gains for the average worker. Normally, when workers make more things during a work day, they get paid more for that day’s work. From 1948 to 1979, both hourly wages and productivity roughly doubled. But from 1979 to 2013, productivity rose 65% while average hourly compensation rose just 8%; those at the bottom and middle of the income ladder saw little of those gains.

Wages for everyone at or below the 30th percentile of the income distribution have essentially been flat, while wages for the poorest 10% of workers have fallen during that time period. At all income levels, women earn less on average than men do.  Most wage growth has flowed to the top 1% of earners, posting a 153% increase in wages. Since wages for the lowest income group have fallen while wages at the highest income group have grown, income inequality has also increased.  Piketty was right.

The S&P 500 index hit another record high close today, and even at that it’s just up about 5% year to date. The best performing market year to date is in Dubai; posting a 56% return since the start of the year and posting a 117% return for the past 12 months. The strongest S&P 500 subsectors this year include oil & gas equipment and services, which is up 17%; oil & gas exploration and production, up 15%; real estate investment trusts, up 15%; natural gas utilities, up 21%; and electric utilities, which have risen 14%, largely on the back of some big mergers.

The top performing stocks in the S&P year to date include: Forest Labs, up 60%, a takeover target; Nabors Industries, a contract oil driller based in Bermuda is up 54% year to date; Electronic Arts, the video game developer is up 51%; Keurig Green Mountain has returned 50% this year, this is the coffee company that makes those little single serve containers of coffee; Newfield Exploration, an oil and gas exploration and development company out of Texas is up 49% since the start of the year; Delta Airlines is up 47% after rejoining the S&P 500 index; and Pepco, the Washington DC based utility is up 47% YTD, after agreeing to be acquired by Exelon. Probably nobody picked those stocks as the top performers at the start of the year.

After the close of trade today, comes word that Sprint is nearing an agreement price to acquire T-Mobile for about $40 a share, or around $32 billion, a 17% premium to the closing price today. There will be regulators to deal with. An announcement and an actual deal are still down the road. If you are unhappy with the service and price you pay for your mobile phone, this won’t help.

A federal appeals court has overturned a decision by Judge Jed Rakoff to reject a federal settlement deal with Citigroup. Judge Rakoff had considered the Citigroup-SEC settlement to be little more than a slap on the wrist. The original case accused Citigroup of duping investors into buying tainted CDO’s, Collateralized Debt Obligations. The bank agreed to pay $285 million to settle the civil fraud case, without admitting wrongdoing.

Judge Rakoff called the fine “pocket change” for the bank and said the settlement deprived the public “of ever knowing the truth in a matter of obvious public importance.” And now the court of appeals decision is going to rein in judicial discretion even more. The ruling essentially says that a judges job is not to search for the truth.  One small victory for Judge Rakoff: the SEC last year reversed its longstanding yet unofficial policy of allowing companies to neither “admit nor deny wrongdoing,” signaling that it would force admissions in particularly egregious cases.

If only the SEC had the backbone to pursue a particularly egregious case.

The G-7 or Group of 7 is meeting today and tomorrow; it used to be the G8 until Putin invaded Crimea, and so Russia was kicked out of the clubhouse. A draft of the G7 communique calls on Russia to "accelerate withdrawal of military forces from the eastern border with Ukraine" and "exercise its influence among armed separatists to lay down their weapons".

More important is how Europe will deal with energy security as the continent relies on Russia for about a third of its oil and gas, a fact that gives Putin considerable leverage over the EU. The G7 draft communique says: "The use of energy supplies as a means of political coercion or as a threat to security is unacceptable." Euro leaders say they are committed to diversifying energy sources away from Russia, but it won’t happen overnight. Complacency on the energy front seems like a really big mistake.

As the G7 meeting wraps up, the various leaders will head to France on Friday to mark the 70^th anniversary of the D-Day invasion at Normandy. Putin will be there. No negotiations or diplomatic level talks are planned but it should make for some interesting photo ops.

And before the D-Day anniversary there will be an uncomfortable dinner between President Obama and French President Hollande, who will make the case that the French bank, BNP Paribas should not be fined $10 billion for money laundering. Naturally, this has BNP clients nervous about what all this means for business, and the upper echelons of BNP management nervous about how their employees might respond to questions about money laundering.

Once upon a time BNP thought they could beat the rap. BNP showed prosecutors a memo that the bank thought would explain and possibly mitigate the conduct. The memo, drafted around 2004 by an outside law firm, essentially authorized the bank to process certain transactions for Sudan, as long as BNP’s employees in New York were not involved in the arrangement. BNP argued that it lacked the intent to commit a crime, saying that it followed the law firm’s directive. That legal argument, known as the “advice of counsel” defense, prompted prosecutors to pore over the single-page memo and weigh the bank’s argument. Ultimately the prosecutors concluded that the memo alleviated only a small fraction of the wrongdoing. Apparently hiring lawyers to tell you that you can do whatever you want turns out to be a little bit less than an airtight legal strategy.

Wednesday, April 16, 2014 - What is Really Plausible

What is Really Plausible

by Sinclair Noe

DOW + 162 = 16,424
SPX + 19 = 1862
NAS + 52 = 4086
10 YR YLD + .01 = 2.63%
OIL + .05 = 103.81
GOLD - .20 = 1303.20
SILV + .07 = 19.73

Let’s start with some earnings news and then we’ll move over to economic data.

Google posted $3.4 billion in net income, or $5.04 per share, in the three months ended March 31, compared to $3.3 billion, or $4.97 per share, in the year-ago period. Revenue rose 19% to $15.4 billion, but analysts had estimated $15.5 billion, and the shares were getting clobbered in late trades.

IBM reported its lowest quarterly revenue in five years; IBM reported revenue of $21.7 billion for the quarter, but that marks the eighth consecutive decline in quarterly revenue. The company has been restructuring its business by cutting jobs and selling its low-end server business. This is not what you would call a growth model.

Also, from the faulty business model file: Bank of America posted a $276 million loss for the most recent quarter. The financial results included a pre-tax expense of $6 billion, or approximately 40 cents a share after tax, to cover litigation costs as the bank moved to resolve mortgage-related litigation fallout from the financial crisis that began in 2007 and other issues; far worse than the $3.7 billion investors had braced for. The bank today agreed to a $584 million settlement of litigation over nine residential mortgage-backed securitizations insured by the Financial Guaranty Insurance Company. The FGIC said the securitizations were sponsored by Countrywide, which Bank of America bought in 2008.

Since the 2008-2009 financial crisis, Bank of America has logged some $50 billion of expenses for settlements of lawsuits and related legal costs, before taxes. Without those charges, its income before taxes would have been about three times higher. When does it end? How do you factor this when you try to value shares of a company? The simple answers: it ain’t over yet, and don’t even try.

In economic news: China reported that its economy grew at its slowest pace in 18 months at the start of 2014, but the increase was better than expected and showed some improvement in March.

From the Census Bureau: privately owned housing starts in March increased 2.8% from February to a seasonally adjusted annual rate of 946,000; single family housing starts increased 6% from the month before at an annual rate of 635,000. Building permits authorized were down 2.4% from February at a seasonally adjusted annual rate of 990,000, but it’s still 11.2% higher than March of last year.

The Federal Reserve reports industrial production increased 0.7% in March, following a 1.2% advance in February; for the first quarter industrial production moved up at a 4.4% pace. The increase in industrial production, which beat economists' expectations for a 0.5% gain, reflected in part a 0.5% rise in manufacturing output. There were also hefty increases in production at mines and utilities.

The Federal Reserve has just released its April Beige Book, a collection of anecdotes on economic conditions from business contacts across each of the 12 Fed districts. Economic growth increased and consumer spending rose, at least for people who weren’t completely snowed in. The Fed seemed quite fascinated with the weather, mentioning it more than 100 times; it’s like they had never seen snow before, and they seemed amazed that it makes actual work difficult for some people.  

Transportation, manufacturing, financial services, and auto sales all improved, though the reports on residential housing markets were “varied.” The Beige Book also talks of delays to crop plantings and shipments of commodities, as well as a pig virus that hurt hog farming. Labor market conditions continued to slowly improve with minimal wage pressure, and prices were generally stable or slightly higher.

Fed Chair Janet Yellen delivered a speech to the Economic Club in New York. She said the economy is improving, it will continue to improve, and by 2016 it will be normal, and then it will all be good. Yellen said: “I find this baseline outlook quite plausible.”

Yellen laid out 3 questions that will guide the Fed policymakers: Is there still significant “slack” in the labor market? Is inflation moving back toward 2 percent? What factors may push the recovery off track?

Is there still significant “slack” in the labor market? Why yes, yes there is. The unemployment rate is at 6.7% and Yellen would prefer to see it closer to 5.2% or 5.6% and she thinks it will take about 2 more years to get there. Further slack exists in the share of the workforce working part time and the long term unemployed and the low level of participation in the workforce. Toss in almost no wage pressure.

Is inflation moving back toward 2 percent? Yellen said inflation significantly persisting below 2% was more likely than inflation moving substantially above 2%. At the moment, the Fed’s favorite measure of inflation is less than 1%, well below the Fed’s annual inflation target of 2%.Inflation is likely to gradually move back toward the central bank’s target. Yellen said that to some extent, the low rate of inflation seems to be due to factors that are likely to be temporary, including lower consumer energy prices and a drop in import prices.

What factors may push the recovery off track?  Yellen says there can be a lot of ‘twists and turns’ in the economy” and the central bank has no “fixed idea” about what will come to pass. The Fed will try to set the course and Yellen said the central bank’s new forward guidance can serve as an “automatic stabilizer” that helps investors from overreacting to “twists and turns” the economy may take.

She cited the ongoing fiscal drag on the economy. This is a recurring theme; we heard Bernanke talking about this for a long time. Allow me to translate from Fedspeak to plain language. The Federal Reserve is responsible for monetary policy; Congress handles fiscal policy. So fiscal drag means that the policies laid out by Congress have hurt the economy. The Fed has tried to stimulate the economy, much like stepping on the accelerator while the Congress has been applying the brakes. That’s a bit simplistic because there are other factors at work. The Fed is stepping on the gas, the Congress is stepping on the brakes, and we’ve got rotten, ill-behaved bratty children in the back seat, reaching over and grabbing the steering wheel and threatening to drive into a brick wall; in this example, the bratty kids in the back seat are the banksters.

Just a little reminder of a story from the Summer of 2013; when we learned that Goldman Sachs was in the aluminum business. Goldman had 27 industrial warehouses in the Detroit area, where they stored aluminum. Goldman also had an interest in the financial markets for aluminum; they bet on price movement in the commodity; and they exploited pricing regulations set up by an overseas commodities exchange, which essentially allowed them to keep aluminum in storage longer than allowed, which keeps it off the market and out of production, which jacks up prices, based upon simple supply-demand, and then they bet on those higher prices. They literally had trucks moving aluminum from one warehouse to another, all around Detroit, but they wouldn’t ship it out for production. The move cost consumers more than $5 billion over the last 3 years.

The inflated aluminum pricing is just one way that Wall Street is flexing its financial muscle and capitalizing on loosened federal regulations to sway a variety of commodities markets. The maneuvering in markets for oil, wheat, cotton, coffee and more have brought billions in profits to investment banks like Goldman, JPMorgan Chase and Morgan Stanley, while forcing consumers to pay more every time they fill up a gas tank, flick on a light switch, open a beer or buy a cellphone. Federal regulators were also looking at JPMorgan and 3 other banks for rigging electricity prices.

Using special exemptions granted by the Federal Reserve and relaxed regulations approved by Congress, the banks have bought huge swaths of infrastructure used to store commodities and deliver them to consumers. After hearing of all the abuses by the banks, some people thought it might be good to rethink these policies. And about 9 months have passed, and finally 2 senators, Sherrod Brown and Elizabeth Warren, have sent a letter to the Fed, suggesting that "As a general matter, [big banks] should be prohibited from owning physical assets like warehouses, pipelines, and tankers."

Aluminum prices have continued to rise not necessarily because the commodity has become more valuable or scarce, but simply because the wait times for physical delivery have steadily grown longer. In some cases, the wait has lasted more than a year. Meanwhile, commodity traders have come up with a unique solution to banks hold physical commodities in warehouses to manipulate prices. The London Metals Exchange will give traders the ability to hedge aluminum prices, as the commodity continues to rise due to lengthy delivery times that have thrown a wrench in a number of supply chains.

Here are a few facts for your consideration: roughly one-third of everything we buy goes to interest; the interest goes to private banks; at the height of the financial crisis over 40% of US corporate profits went to the financial industry, up from 7% in 1980. The simple reality is that I we could just get those crazy banksters under control, we would have at minimum a couple of trillion extra dollars floating through the economy, and we wouldn’t have to worry (as much)  about the Fed and Congress and monetary policy versus fiscal drag, and we would all be talking about the phenomenal economic recovery. And that is not only plausible, but that’s a fact.

Wednesday, March 05, 2014 - Not Much Change

Not Much Change

by Sinclair Noe

DOW – 35 = 16,360
SPX – 0.1 = 1873
NAS + 6 = 4357
10 YR YLD + .01 = 2.70%
OIL – 2.40 = 100.93
GOLD + 2.40 = 1337.80
SILV + .02 = 21.26

ADP, a payroll processing company, reports its own monthly jobs estimate each month, just before the government comes out with its monthly jobs report. Today, ADP said the economy added 139,000 new jobs in February; they revised the January number down to 127,000 from the previously reported 175,000. When the Labor Department reports on jobs Friday morning the best guess is about 150,000 jobs and the unemployment rate holding at 6.6%. So, the ADP report is reasonably close.

Separately, initial jobless claims for the past week did not point to any improvement in the labor market with initial claims up 14,000 in the February 22 week to a 348,000 level.

In other news, the Institute for Supply Management’s non-manufacturing index slipped to 53.5 in February from 54 the previous month.

This afternoon the Federal Reserve published its Beige Book, which is a compilation of reports and observations from the 12 Fed districts. Growth slowed in Chicago and activity was stable in Kansas City. While the other eight districts reported growth, the Fed said it was characterized as "modest to moderate" in most cases, an overall downgrade from its last report on January 15, which showed "moderate" growth in nine regions. Business contacts were still upbeat, and real estate activity picked up in some areas, and travel and tourism remained strong. Retail sales growth softened in most districts, partly due to weather. Factory output and sales were affected in regions including Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, and Dallas, where the weather was blamed for utility outages, disrupted supply chains and a slowdown in hiring.

So, the latest Beige Book still reflects weather disruptions. If you were waiting for clean data, this wasn’t it. We might not get clean data from the Friday jobs report. We may need to rethink our idea of data clean from weather disruptions because it seems we are experiencing bad weather with regularity, whether it be the polar vortex or ice storms or drought or hurricanes or tornadoes. If it’s not one thing it’s another.

The big brouhaha in Ukraine seems to be a bit calmer today. The European Union is ready to provide $15 billion of financial support to Ukraine over the next couple of years by way of a series of loans and grants. The assistance would be delivered in coordination with the European Bank for Reconstruction and Development and the European Investment Bank, and is in part contingent on Ukraine signing a deal with the International Monetary Fund. Yesterday, Secretary of State John Kerry visited Kiev to offer moral support and a $1 billion aid package to a Ukraine fighting to fend off bankruptcy. Money soothes the savage beast. And so, there is no fighting today; that’s good.

In time we will probably find out more and more details about who and how this Ukrainian revolution came to be and why; and the best guess is that it was not quite an organic uprising of the masses; and it was probably not a coincidence that a nostalgic stroll along old Cold War paths coincided with Defense Secretary Chuck Hagel’s proposal to cut back Pentagon spending. This is not to say there are no problems in the Ukraine, there are. Internal divisions in Ukraine are real and enduring. Russian aggression in Ukraine is bad, and there really is no justification for this kind of military intervention. US credibility and security is not at stake and there really isn’t anything we can do anyway, short of a full-fledged return to the Cold War. Some people may want that but I don’t much care for the notion.

It’s a good story to imagine the downtrodden Ukrainian everyman fighting for freedom from the Russian overlords, but there’s a better chance that the real story will be told by following the money trail.

In 1998, Washington state voters raised the state’s minimum wage and linked it to the cost of living. Over the past 15 years, the minimum wage in Washington has climbed to $9.32 an hour, the highest in the country. Payrolls at Washington's restaurants and bars, portrayed as particularly vulnerable to higher wage costs, expanded by 21%. Poverty has trailed the US level for at least 7 years.

According to a Congressional Budget Office report published February 18, increasing the minimum wage would lift 900,000 people out of poverty and add $31 billion to the earnings of low-wage Americans, but it might reduce employment by up to a million jobs; actually that last point is an area where the CBO report was fuzzy, saying it might cost up to a million jobs or it might not reduce  employment; as a result, most people split the difference and say it will reduce employment by 500,000, but that’s not what the report says, and it’s  not what the data from Washington state says.

One possible explanation is that businesses have plenty of ways besides job cuts to absorb the costs of a minimum-wage increase: price increases, reductions in profits and savings from lower turnover can help soak up the shock.

As of January, 21 states and the District of Columbia had a higher minimum wage than the federal floor. Cities including San Francisco and Santa Fe, New Mexico, require even higher hourly earnings than the proposed federal level, at $10.74 and $10.66 respectively.

New Jersey voters in November approved increasing the minimum wage by $1 an hour to $8.25, tying future increases to the consumer price index. In January, after the raise took effect, private employers added 8,320 jobs in New Jersey, according to ADP Research Institute. That was the fastest pace of job growth since December 2012.

Today, the Center for American Progress issued a report showing that raising the minimum wage from $7.25 to $10.10 an hour would reduce federal food stamp spending by $4.6 billion a year. Last year, a report done by researchers at Berkeley and the University of Illinois asserted that taxpayers are spending nearly $7 billion a year to supplement the wages of fast-food workers, many of whom earn the minimum wage or close to it.

Now, let’s get caught up on banks behaving badly. The latest news on this front regards Citigroup which disclosed on Friday that it had been defrauded of $400 million in a scheme involving a financially shaky oil services company in Mexico. And while that was going on, a Citigroup affiliate based in Los Angeles received a grand jury subpoena from federal prosecutors in Massachusetts related to anti-money-laundering compliance. The focus of the subpoenas is unclear.

The affiliate has also received a subpoena from the Federal Deposit Insurance Corporation related to its anti-money-laundering program and the Bank Secrecy Act. The affiliate, Banamex USA, provides banking services to individuals and small businesses in the United States and Mexico. Until recently, it was a large player in transferring money across the border between family members.

Apparently the two issues, one involving fraud and the other involving money-laundering compliance, are unrelated.

In 2006, the bank’s computer systems got fouled up and certain business units failed to process Citi’s foreign transactions to ensure compliance with anti-money laundering regulations for about 4 years until the computer error was fixed. In 2012, Banamex USA entered into a consent order with the FDIC and California Department of Financial Institutions to improve its oversight and tracking systems. In 2013, Citigroup entered into another consent order with the Federal Reserve and agreed to take companywide actions also intended to bolster its compliance efforts. Now we have subpoenas in the case.

Meanwhile, the New York Times is reporting that the Treasury Inspector General believed that JP Morgan had used attorneys to “investigate” its conduct in dealing with Bernie Madoff with the intent of impeding regulatory scrutiny and allowing staff to get away with perjury. In this case it goes back to the idea of what JP Morgan knew about Madoff’s Ponzi scheme and when did they know it.

We know that JPMorgan was Madoff’s banker. JPMorgan hired lawyers to investigate, or maybe they hired outside law firms as a way to put a shield around the questionable activity, to impede regulators from getting to the bottom of criminal or merely potentially costly conduct. This raises the question of attorney client privilege.

Federal regulators at the Office of the Comptroller of the Currency sought copies of the lawyers’ interview notes, hoping they would open a window into the bank’s actions. The issue gained urgency in 2012, when the comptroller’s office conducted its own interviews with JPMorgan employees and discovered a “pattern of forgetfulness.”

Suspicious that the memory lapses were feigned, the regulators renewed their request for the interview notes held by JPMorgan’s lawyers. But JPMorgan, which produced other materials and made witnesses available to the comptroller’s office, declined to share those notes. In its denial, the bank cited confidentiality requirements like the attorney-client privilege. The inspector general argued that the lawyers’ interviews were essentially “made for the purpose of getting advice for the commission of a fraud or crime.” The reporters also stress that the use of attorneys as an information shield for banks is already troublingly widespread.

But the Department of Justice will not pursue subpoenas of the potential perjury or potential obstruction of justice, because, according to a DOJ letter the action would “risk developing negative precedent that could result in harm to the long-term institutional interests of the United States.”

Just in case you were wondering, too big to fail and too big to jail is still the law of the land. 

Wednesday, January 15, 2014 - A Few Pages of Pork

A Few Pages of Pork

by Sinclair Noe

DOW + 108 = 16,481
SPX + 9 = 1848.38
NAS + 31 = 4214

10 YR YLD + .01 = 2.88%
OIL + 1.75 = 94.34
GOLD – 3.00 = 1243.00
SILV - .05 = 20.30

The S&P 500 hit a record high close, just a few pennies better than December 31^st. The market has had a weak start to January but we're still at elevated levels. The Dow Industrials are about another day like today away from records; that close was 16,576 on New Year's Eve.

A $1.1 trillion compromise spending bill that funds the government through September won approval today from the House of Representatives and now goes to the Senate for consideration. The Senate is expected to also pass the so-called "omnibus" bill and send it to President Barack Obama to be signed into law. The 1,582-page bill eases most of the automatic spending cuts that were part of the sequester and keeps the federal government funded through Sept. 30.

The budget bill calls for 1% increases in the paychecks of federal workers and military personnel, the first raises in three years for most agency workers. The spending measure also would protect disabled veterans and some military spouses from a pension cut set to go into effect in 2015.The bill would provide nearly $92 billion for US military operations abroad, mostly in Afghanistan, plus about $7 billion for disasters and other emergencies. That was just slightly less than last year’s war spending but about $44 billion less than was provided in 2013 for disasters, after Hurricane Sandy ravaged the Northeast in October 2012.

Democrats like a $1 billion increase in Head Start funding for early childhood education from its recent low point after forced budget cuts last year. Half of the money will go to help children 3 years old and younger, touching on an Obama administration priority. For Republicans, the compromise reduces funding to two of their least-favorite agencies: the Internal Revenue Service and the Environmental Protection Agency. Democrats also blocked GOP-sought curbs on the Environmental Protection Agency’s power to regulate utilities’ greenhouse gas emissions. The bill includes  an extra $155 million worth of financing for the Department of Energy to promote its nuclear projects. There is also money for the coal industry. The measure provided money for Obama’s 2010 health care overhaul and his revamping of federal oversight of the nation’s financial markets, though not as much as he requested. There are also cuts for financing the Securities Exchange Commission. Overall, federal spending would be lower than the final budget of President George W. Bush's administration.

Out of 1,582 pages I'm guessing we'll find a few pages dedicated to pork.

In the latest economic data, a measure of inflation at the wholesale level, the seasonally adjusted Producer Price Index rose 0.4 percent last month, the biggest increase since June, although inflation pressures remained benign. 

In its latest Beige Book report on business activity, the Fed said the economy grew at a moderate pace from late November through the end of 2013, with some regions of the country expecting a pickup in growth. Specifically, 9 of the 12 regions reported moderate growth, and 2 regions reported modest to moderate growth. Moderate is a little better than modest, both are better than mediocre, and that's just a smidge better than maudlin. In other words, the Fed's Beige Book is not very precise. They say that tourism has picked up in Florida, and that ripples out to help lift other parts of the Floridian economy. Around the Gulf of Mexico there has been significant energy investments, and that also ripples. In the Midwest, the auto industry has perked up, and that ripples out to other industries. Retail sales were pretty good across the country. Wages are still a problem across the country, and not likely to get better. Everything else was up just a little everywhere except the St. Louis region. Go figure.

The World Bank reported that advanced economies appeared to have turned the corner after five years of financial crises and recession. It forecast global growth will firm to 3.2% this year from 2.4% in 2013. The bank lowered its 2014 China GDP forecast to 7.7% from 8.0% forecast in June, but raised its Eurozone GDP estimate to 1.1% from 0.9%, and kept its US GDP estimate at 2.8% and its projection for Japan GDP at 1.4%.

The International Monetary Fund expects global growth to pick up this year, though it should still remain below its potential of about 4 percent. IMF Managing Director Christine Lagarde said: "Overall, the direction is positive, but global growth is still too low, too fragile, and too uneven," and she says one of the biggest risks is deflation.

Earnings reporting season, and the big banks dominate the earnings news this week. Bank of America reported 4^th quarter net income of almost $3.2 billion. Revenue increased 14% to $22.3 billion. Consumer banking had its best quarter since 2011, the wealth management and global banking divisions posted record revenues. The bank made $11.6 billion in home loans, down 49% from the third quarter. BofA isn't alone in this. 

Both JP Morgan and Wells Fargo reported declines in their mortgage businesses yesterday. BofA' mortgage unit lost $1.1 billion, which was actually an improvement from a loss of $3.7 billion same time last year, but much of the earlier losses were due to legal expenses, which, at $2.3 billion for 4Q are still a bit of an embarrassment. BofA says the problem now is that demand for mortgages has dropped. This might explain the Fed taper; the banks just aren't producing mortgages. And the banks are setting aside fewer reserves for mortgage related losses. What could go wrong?

The housing market may be slowly improving, but weak spots remain. In 15 states, the share of “deeply underwater” foreclosures is larger than those with equity, according to housing data analyst RealtyTrac. But, overall, the December data show those deeply underwater foreclosures declining and homes rich in equity increasing. During the housing downturn we saw a downward spiral of falling home prices resulting in rising negative equity, which in turn put millions of homeowners at higher risk for foreclosure when they encountered a trigger event such as job loss. Now we are seeing the reverse trend: rising home prices resulting in falling negative equity, which in turn is giving millions of homeowners a lifeline to avoid foreclosure.

The data measure underwater status by comparing the value of a home loan to the value of the home itself. A foreclosure was defined as “deeply underwater” when the homeowner owed at least 25 percent more than the value of the property. (The loan-to-value was 125 percent or greater.) A foreclosure with equity was defined as one where the value of the loan was equal to or smaller than the value of the home. (A loan-to-value ratio of 100 percent or less.)

The states with the highest percentage of deeply underwater foreclosures were: Nevada (65 percent of foreclosures were deeply underwater), Florida (61 percent), Illinois (61 percent), Michigan (55 percent), and Ohio (48 percent).

But that data is just for those homes in foreclosure. In two states especially hard-hit by the housing crisis, Nevada and Florida, “deeply underwater” properties accounted for more than one in every three homes.

States with the most equity-rich homes — where the loan value was well below the value of the home — included Hawaii (36 percent), New York (33 percent), California (26 percent), Montana (24 percent), and Maine (24 percent). D.C. also had a rate of 24 percent.

Five bank regulatory agencies approved a tweak to the Volcker rule that would allow banks to keep interests in certain funds backed by trust-preferred securities. The change was aimed at easing the concerns of small banks that they needed to dump certain investments they thought would be allowed under the rule, losing money in the process.

The American Bankers Association, or ABA, a bank trade group, sued regulators, and lawmakers from both parties have backed the banks. After regulators announced the revision, the bankers group said it was considering the change and would decide whether to continue with its lawsuit.

The Volcker rule, which was required by the 2010 Dodd-Frank law, prohibits banks from making speculative bets with their own money and restricts their investments in certain funds. Five agencies, including the Federal Reserve and the Federal Deposit Insurance Corp, were involved in writing the rule. Smaller banks claimed that, as an unintended consequence of the final version, they would need to dump funds backed by trust-preferred securities, or TruPS, which are collateralized debt obligations, or CDO's that have characteristics of debt and equity. These CDOs were issued mainly by small banks and were attractive because they counted towards capital for regulatory purposes but they were regarded as debt instruments for tax purposes, so payments on them were deductible as interest. 

Regulators said banks could keep certain collateralized debt obligations backed by TruPS established before May 2010 and obtained before the Volcker rule was finalized last month. The agencies also said banks can continue to act as market makers in the TruPS-backed funds. Banks have 30 days to comment on the changes after which regulators have the power to make additional tweaks if necessary. Even the dumbest banker can get around the Volcker rule. The regulators started with a weak statute, and managed to make it weaker. 

Wednesday, December 04, 2013 - The Defining Challenge

The Defining Challenge

by Sinclair Noe

DOW – 24 = 15,889
SPX - 2 = 1792
NAS +0.80 = 4038
10 YR YLD + .05 = 2.83%
OIL + 1.25 = 97.29
GOLD + 19.00 = 1244.30
SILV + .54 = 19.82

December can be a cold, cold month. At least that's how the equity markets are starting the month; four losing sessions. Part of this might be the big institutional investors, the big hedge funds and money managers, looking around and realizing the market is up 30% or so, and that would be a good year, so why no lock in a few profits. No need to worry about the budget battle in Washington; no need to worry about the Federal Reserve surprising people with a premature taper; no need to worry about a strong jobs report on Friday. In this crazy market where good economic news gets traders worried about the Fed taking away the punch bowl, today we had some reasonably decent economic news and another drop in the markets.

Let's start with the economic reports. ADP, the payroll processing firm, has a monthly report on private jobs; they issue the report just before the monthly official government report on jobs, the BLS non-farm payroll report. The ADP report is not great at predicting the government report, but its one of the better guidelines we have. Today, ADP reported companies added to their payrolls by a net 215,000 in November, and they revised the October number higher to 184,000.

Manufacturers, builders and other goods-producing industries increased headcount by 40,000, the most this year. Employment in construction climbed by 18,000. Factories also added 18,000 jobs, the biggest gain since February 2012. Trade, transportation and utility companies created 45,000 jobs last month. Companies employing 500 or more workers added 65,000 jobs. Medium-sized businesses, with 50 to 499 employees, took on 48,000 workers and small companies expanded payrolls by 102,000.

ADP typically underestimates the number of jobs added to the economy. The government jobs report is Friday morning; the average estimate is for 180,000 net new jobs in November.

In a separate report, contracts signed to buy newly built homes jumped 25% in October month to month. Now let's dig into the numbers, because the numbers are a bit unusual. In September, contracts to buy new homes dropped 6% from August. So there was a big drop in September and an even bigger bounce up in October. A couple of theories behind the numbers. First, is the idea of pent-up demand; the government shutdown caused potential buyers to wait, and also interest rates have been climbing, pushing potential buyers to jump now rather than wait for higher rates later. The other theory is that there's a large margin of error in this report and we'll see the number revised next month.

Meanwhile, the Institute for Supply Management's non-manufacturing index dropped to 53.9 in November from 55.4 in October. A reading above 50 indicates expansion in the services sector of the economy, but clearly expanding a little slower. The ISM manufacturing index, released Monday, showed an increase to 57.3 from 56.4.

Meanwhile, the Federal Reserve released its Beige Book this afternoon. The Beige Book is a business survey, which contains anecdotal reports from the 12 Fed district banks, and it's published two weeks before the officials meet to set monetary policy at the FOMC meeting. It's called Beige Book because it has a beige cover, although I suspect it is also descriptive of the writing style.

Anyway, here's the synopsis: consumer spending increased in most of the country, with retailers expressing optimism about holiday sales; hiring showed a modest increase or was unchanged; manufacturing activity continued to expand in most districts, with gains noted in the motor-vehicle and high-technology industries; demand for professional business services experienced stable to moderate growth, especially in computer technologies.

And the Commerce Department reported this morning that the October trade deficit decreased to $40 billion. Total October exports came in at $192 billion compared to imports of $233 billion, resulting in a deficit of $40 billion, down from $43 billion in September. Oil prices were just under $100 in October, down from $102 in September, and prices will likely be down even further in November. The petroleum deficit has generally been declining and is the major reason the overall deficit has declined since early 2012.

Meanwhile, remember the budget negotiations? That's where each political party draws a line in the sand, and a bipartisan committee dances around the line and no later than December 13^th, they are supposed to come up with a deal that nobody could love. There is broad agreement that a portion of the sequester should be replaced with targeted cuts to discretionary spending. But Democrats demand revenues in the mix and Republicans categorically reject new taxes. The dance of legislation is reportedly close to finding some syncopation, which would involve an agreement to set a spending level for the next fiscal year above the $967 billion in place under current law.

Also, it appears that both sides are getting closer to agreement on $80 billion in savings to replace the cuts from sequestration over the next 2 years; shared among defense and non-defense programs alike. Other items being considered to pay for it include selling off the broadband spectrum in auction (essentially a government yard sale), increasing TSA fees (in other words, it'll cost more for an airline flight), plus changes in postal service and some reform to federal pensions but no structural changes to entitlement programs.

If the budget committee can't reach a deal by the December 13 deadline, House Speaker John Boehner has said that he will push for a continuing resolution to fund the government past Jan. 15 at the $967 billion level. Apparently both sides realize that shutting down the government is not a popular idea, but short-term stopgap continuing resolutions are getting a bit stale as well.

Somewhere, in the vague and distant past, I remember hearing something about closing loopholes and reforming the tax code but that would require roll up your shirt sleeves, honest work, and we know that Congress has nasty aversion to that four letter word.

Some things never change.

Banks cheat. They get caught sometimes. They pay a fine. It's the cost of doing business.

EU antitrust regulators have fined six financial institutions including Deutsche Bank, Royal Bank of Scotland, Citigroup, Societe Generale, JPMorgan and brokerage RP Martin a record total of $2.3 billion for rigging financial benchmarks. The penalty is the biggest yet to be handed down to banks for rigging the benchmarks used to determine the cost of lending; the benchmarks involved are the London interbank offered rate, or Libor, the Tokyo interbank offered rate and the euro area equivalents. They are used to price hundreds of trillions of dollars in assets ranging from mortgages to derivatives.

EU Competition Commissioner Joaquin Almunia said in a statement: "What is shocking about the Libor and Euribor scandals is not only the manipulation of benchmarks, which is being tackled by financial regulators worldwide, but also the collusion between banks who are supposed to be competing with each other."

Yes, I'm shocked, shocked to find that gambling is going on in here!

Authorities around the world have so far handed down a total of $3.7 billion in fines to UBS, RBS, Barclays, Rabobank and ICAP for manipulating rates, while seven individuals face criminal charges.

UBS paid a record fine of $1.5 billion late last year to the US Department of Justice and the UK's Financial Services Authority for rate-rigging. EU fines can reach up to 10 percent of a company's global turnover. UBS blew the whistle on the Libor and Tibor cases and will not be fined as a result. Barclays will escape a fine in the Euribor case because it alerted the Commission to the offence.

The European Commission said it would continue to investigate Credit Agricole, HSBC, JPMorgan and brokerage ICAP for similar offenses.

And by the way, I don't know how the regulators come up with the amount they decide to fine the banksters. I guess they pull a number out of the hat. I'll check on that.

Moving on. Now that the government has fixed the healthcare.gov website and Obamacare is experiencing smooth sailing. Huh? What? Squirrel...

Anyway, President Obama turned his focus today to the pocketbook issues that Americans consistently rank as a top concern, arguing that the dream of upward economic mobility is breaking down and the growing income gap is a "defining challenge of our time."

"The basic bargain at the heart of our economy has frayed," the president said in remarks at a nonprofit community center a short drive from the White House in one of Washington's most impoverished neighborhoods.

The president vowed to focus the last three years of his presidency on addressing the discrepancy and a rapidly growing deficit of opportunity that he said is a bigger threat than the fiscal deficit. Obama said increasing income inequality is more pronounced in the United States than other countries. He said Americans should be offended that a child born into poverty has such a hard time escaping it, saying: "It should compel us to action. We're a better country than this." Obama did not propose any new policy initiatives in the speech.

The speech comes amid growing national and international attention to economic disparities — from the writings of Pope Francis to the protests of fast-food workers across the country. The president cited the pope's question of how it isn't news when an elderly homeless person dies from exposure, but news when stock market loses two points.

Wednesday, July 17, 2013 - Good Markets, Bad Economy

Good Markets, Bad Economy

by Sinclair Noe

DOW + 18 = 15,470
SPX + 4 = 1680
NAS + 11 = 3610
10 YR YLD - .04 = 2.49%
OIL + .59 = 106.59
GOLD – 16.90 = 1275.60
SILV - .72 = 19.29

Let's start today with a quick rundown of a few earnings reports.

Intel reported second quarter net income of $2 billion, down from $2.8 billion a year ago. Revenue was $12.8 billion, and they expect third quarter revenue around $13.5 billion, both revenue numbers and guidance were below current estimates.

IBM posted earnings of $4.3 billion on revenue of $24.9 billion. Earnings were up slightly from a year ago, while revenue was down slightly.

Bank of America reports net income rose 63 percent, to $4 billion from $2.5 billion in the period a year earlier, while revenue increased to $22.7 billion from $22 billion. The bank benefited from higher revenue from equities sales and trading and a reduction in expenses, but its mortgage unit continued to struggle.

This seems to be a recurring trend for the big banks; more profits from the Wall Street business side, less revenue from the old fashioned loan business, less money set aside for reserves. The concerns are that trading performance tends to be uneven over time, and cutting costs can only go so far, it doesn't increase revenue.

June housing starts fell 9.9% to an annualized rate of 836,000—the lowest level since August 2012. The drop in housing starts was led by a decline in multifamily construction, which fell 26.2% versus 0.8% for single-family houses.

The Federal Reserve released its Beige Book survey today, and it indicates “modest to moderate” growth. Housing construction and home prices improved, while consumer spending increased in most districts, fueled by rising car and truck sales. The housing recovery is also driving more production of lumber, materials and construction equipment.

The report says hiring held steady or increased in most districts. But employers in some districts were reluctant to hire permanent or full-time workers. Employers have added an average of 202,000 jobs a month this year, up from about 180,000 a month in the previous six months. Still, growth has been weak.

Fed Chairman Ben Bernanke went before the House of Representatives today to deliver his semi-annual testimony, which was also pretty beige. Bernanke said: “We’re going to be responding to the data. If the data are stronger than we expect, we’ll move more quickly” to reduce bond purchases. If data “don’t meet the kinds of expectations we have about where the economy’s going, then we would delay that process or potentially increase purchases for a time.”

The Fed chairman described labor markets as “far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high.”

And then we have to realize that the Fed's economic forecasting is usually a bit more rosy than realistic. Each year for the past 3 years they've been forced to revise lower. Already this year, economic growth has dropped below expectations. The Fed's prediction of stronger growth in the second half will almost certainly be cut from the current level of 2.5%. The recent spike in inflationary pressures, which is almost entirely due to the surge in energy costs, also negatively impacts the economy. The spike in inflationary pressures in 2011 coincided with the peak in economic activity. And increases in energy prices are highly correlated to recessions, as we discussed yesterday.

So, Bernanke's testimony today confirmed the Fed isn't going to exit QE or taper off from purchases any time soon. They can't reduce liquidity without risking the markets tanking, taking down consumer confidence and negatively impacting the economy. Or, the other way to look at it is that the Fed is the only thing holding up the markets as the economy continues to slowly grind along, or more likely, erode.

The Fed is constantly communicating its intentions regarding rates and it just tends to artificially prop up the markets, resulting in an imbalance, or some think a possible bubble. The Fed has controlled the markets in part starting with the Greenspan Put, then the historically low interest rates, and then the nearly constant infusions of fresh cash for primary dealers by way of massive government bond purchases. By pegging money market rates, the Fed has created fertile ground for carry trades; and the carry trades create an artificially bigger and bigger bid for risk assets. In this kind of environment, it seems prices can only go up.

After all, the Fed is providing what amounts to insurance against downside risk. The super cheap money and the idea that Too Big to Fail won't be allowed to fail, then attracts even more money flowing into even more speculative long positions. The Fed sets near zero interest rate policy well out into the future, and that eliminates any surprises in the yield curve. That, in turn, allows the traders in the money markets to hypothecate and rehypothecate securities without worries.

The monetary policy of the Fed serves to prop up risk assets but it doesn't do much to drive economic growth. There may be some trickle down effect but not enough to lift economic growth. The old fashioned ideas of credit creation aren't working. We've seen this failure as the big banks have been reporting earnings. The big banks have been reporting remarkable profits, but it comes from their trading desks; gambling in high risk assets; and it comes from setting aside fewer reserves. They just aren't making traditional loans.

Traditional loans used to get money circulating through the economy. A bank made a loan to a consumer or a business. The consumer or the business then spends the money and that adds to GDP which then increases corporate sales and profits. The money circulates and economic activity increases. But money velocity has dropped, even as the Fed has been shoveling trillions of dollars into the banks; that money hasn't found its way into the broader economy, it's been swallowed up by offshore trading in the highly profitable and incredibly dangerous and unregulated international derivatives markets; or what is sometimes called shadow banking, which has now grown to about $70 trillion.

The shadow banking system has grown to such incredible size without providing any real benefit to the broader economy, and represents a far bigger risk than benefit for GDP growth. The Fed's QE policy, and the reason Wall Street gets it's panties in a wad at the thought that QE might end, is nothing more than a way for the Fed to raise the reserve levels of banks; which means the banks don't have to set aside reserves from their own profits. The money remains on the Fed's books as a credit to the bank, unless the bank chooses to re-invest in some sort of asset purchase; which they typically do; which drives up asset prices, but does nothing for the economy.

So, the economy is not improving, or at the best it is slowly improving, but not enough to reach escape velocity. We've seen some job growth but not enough and the quality of jobs is weak; many of the jobs are part-time or temporary, and wages are shrinking; which means disposable income is shrinking; which mean demand is weak and top line sales are slipping; which means that the way corporations keep profits up is by cost cutting, but we're coming to the end of the rope when it comes to cost cutting. The major market indices are at record highs but the economy is still grinding along in a trough.

So, we've got a multi-trillion dollar shadow banking system propped up by credit creation in the form of QE and leveraged for optimal results; and indeed, the banks have been returning optimal results. But remember that leverage is a two-way street. It works great when the trade goes your way, but it can double your losses when the trade turns against you. What happens when the asset you have leveraged into suddenly begins to move in the wrong direction exposing you to substantial loss - not increased profits? More importantly what happens if the sheer size of your positions are so significant relative to market volume that liquidity disappears and you can't exit the trade without significantly moving the market in the wrong direction? The answer of course is that you are stuck. We've seen this before with Lehman Brothers, with LTCM, and more recently with the London Whale. We will see it again.

Bernanke talked today about the necessary economic conditions that would warrant a change in QE policy. Maybe the Fed could exit QE if there was some fiscal policy that actually had the potential to increase GDP and provide jobs and spur demand. We don't have that. We have a weak economy and highly speculative asset bubbles and all it takes is a blip in liquidity and the whole show could freeze over in a heartbeat.

So for now the market makers will back stop sell offs. Investors will continue to play along because they have no place else to go. And the Federal Reserve will continue with its accommodative policy; they don't really have a choice in the matter.