Wednesday, September 18, 2013 - Surprise, Surprise, Surprise

Surprise, Surprise, Surprise

by Sinclair Noe

DOW + 147 = 15,676
SPX + 20 = 1725
NAS + 37 = 3783
10 YR YLD - .16 = 2.68%
OIL + .43 = 108.50
GOLD + 55.30 = 1366.30
SILV + 1.23 = 23.06

Record highs for the Dow Industrials and the S&P 500, topping the highs of August 2. Surprise, surprise, surprise.

It was not guaranteed the Fed would start to taper, but it was widely expected. We've talked about the reasons why the Fed might taper; the timing of the remaining FOMC meetings this year, some improvement in the economy, fear of frothy markets. Fouhgetaboutit. After two days of meetings, the FOMC decided to continue with the current quantitative easing policy of purchasing $85 billion a month in mortgage backed securities and treasuries.

The punchbowl is full and the party is still rocking. In addition to record highs for the Dow and S&P 500, we saw 5-year Treasury's biggest yield drop since March 2009, the US dollar's third worst day in a year, home-builders had their biggest rally since last summer, and gold had its best day since January 2009.

At least Wall Street institutions and traders love the accommodative policy and the morphine drip of free money from the Fed. So the patient is still on morphine and the reason is because of extreme weakness. The economy just isn't strong enough to survive on its own.

The stock market no longer rallies to the tune of increased retail sales, growing export markets or improved employment expectations, better durable goods orders and such. Good economic news is bad news for the markets because the Wall Street crowd and any investors still playing equities understand full well that any sign of fiscal improvement might mean the end of the private Federal Reserve’s morphine drip. And without the Fed’s artificial stimulus, the financial markets curls up and dies, but of course they'll wipe out your 401k when they go. Wall Street can rally on news the Fed is continuing QE, but the broader economy was never invited to the party.

For the third time this year the central bank cut its forecast for US economic growth in 2013. The Fed now sees the economy growing in a range of 2.0% to 2.3%. Earlier forecasts had predicted growth of 2.3% to 2.6% and 2.3% to 2.8%. Being wrong is nothing new for the Fed. The bank has repeatedly offered forecasts over the past few years that turned out to be way too rosy.

Some other observations noted in the FOMC statement today: the unemployment rate remains elevated, mortgage rates have risen, fiscal policy is restraining economic growth, inflation is less than expected, and the economy just hasn't picked up steam.

What they didn't specifically talk about was the frothy markets. The Fed plan has been to prop up the banks and the financial markets, creating a wealth effect on Wall Street, and then let the wealth trickle down to Main Street. They've done a nice job of creating a wealth effect on Wall Street, but there hasn't been any trickle down; there won't be any trickle down, and once again the Fed is looking like they've painted themselves into a corner with no exit.

By postponing the decision to October or even December or whenever, the FOMC may be setting the market up for an even larger correction when it finally bites the bullet. Every time the Fed has phased out one of its stimulus programs over the last few years, stocks have dropped; first in early 2010, with the winding down of QE1; then in spring 2011, when QE2 ended, and finally in 2012 with the end of Operation Twist. In fact, stocks rallied again only when the Fed announced or started a new round of stimulus.

And there are other considerations: The German election will come this weekend; the Syrian situation looks to be moving toward a solution that doesn't include military intervention although it is still full of obstacles.

Then we face those fiscal policy concerns; what could be some bruising budget battles as hard-line House Republicans vow to either shut down the government or not extend the debt ceiling unless Obamacare is defunded. It won't be defunded, and even the Wall Street Journal is calling the shutdown idea kamikaze missions.

Democrats and Republicans are far apart on spending issues. More important, perhaps, Republicans continue to insist they won’t continue funding government operations—or, when the time comes, increase the Treasury Department’s borrowing authority—until Democrats agree to defund or delay Obamacare. That’s simply not going to happen. No, this isn’t the first fiscal policy standoff of the Obama presidency. In the past, Democrats and Republicans always reached some last-minute agreement. This time each side has a lot less incentive to compromise. And there are apparently no backroom negotiations; there are no calls to dine with the opposition; there is no discussion going on at all at this point.  

What makes this time is different is that, in addition to having carved out hardline positions, neither side has an incentive to back down. In 2011, Obama was willing to give on his demand that revenue increases accompany spending cuts because he understood the apocalyptic consequences of failing to raise the debt ceiling. In late 2012, Republicans knew that the alternative to a small tax increase was for taxes to rise automatically by a much larger amount. The sequester, although unsatisfactory to both sides, was a built-in default position; and indeed that's what happened. This time, on the other hand, every party to the negotiation has reason to welcome the government shutdown that would result if they can’t reach a deal.

Start with the White House, which has been annoyingly open to concessions even when it has all the leverage. Now they are finding no constituency for caving. Add in that the elections have passed and lame ducks find it easier to grow a spine when they don't have to beg for campaign contributions. You can’t rule out the possibility that the White House will blink when the deadline gets close. At the very least, one can imagine Obama signing a short-term government funding measure (known as a continuing resolution) that leaves the automatic sequester cuts in place so long as it doesn’t touch Obamacare. Even if he were inclined to do this, Congressional Democrats seem less willing to support him than in the past. They believe they can demand much more in exchange for saving the GOP from a shutdown.

For the Tea Partiers, a shutdown would mean they forced their leadership to stand up to Obama, which plays well in their districts and the various organs of the conservative movement. And when the GOP inevitably bowed to public opinion and sued for peace, the Tea Partiers would be able to accuse their weak-kneed leadership of caving, thereby enhancing their status within the party, and greatly enhancing contributions.

Then you've got the old line GOP as represented by Speaker Boehner and McConnell from the Senate; they can't control the Tea Partiers, and it appears they will accept a government shutdown because they can't stop it. A shutdown would slow the economy and wreak havoc on people who rely on government services, and wreak havoc on companies that service the government and the people who receive government services, and there will be a massive fallout.

These consequences are nothing alongside the fallout from defaulting on our debt, which will happen if we don’t raise the debt ceiling by mid-October.So a government shutdown gives everyone a chance to sober up before we take on the substantially higher-stakes proposition of avoiding a debt default.

(Link to FOMC statement)

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.