Tuesday, August 19, 2014 - It’s Just a Matter of Time

It’s Just a Matter of Time
by Sinclair Noe

DOW + 80 = 16,919
SPX + 9 = 1981
NAS + 19 = 4527
10 YR YLD+ .02 = 2.40%
OIL (sept) = 94.48
GOLD – 2.00 = 1296.20
SILV - .18 = 19.50

The consumer price index rose a seasonally adjusted 0.1% in July. Food prices rose 0.4%, but energy costs declined 0.3%; the first drop in energy prices since March. Consumer prices have risen an unadjusted 2% over the past 12 months, down slightly from June. Prices surged in the early spring but have since tapered off. Excluding volatile food and energy prices, the core rate has risen 1.9% in the same span, unchanged from the prior month. Almost all of the increase in consumer prices can be traced back to housing costs, or shelter prices; over the past year, shelter prices are up 2.9%.

Hourly wages have risen about 10% overall since June 2009, to $24.45 an hour. But over the same span they’ve slipped 0.3% in “real” or inflation-adjusted terms. Since the Great Recession ended five years ago, the amount of money Americans earn each hour after adjusting for  inflation has actually fallen. And that largely explains why the economy is growing so slowly.

The Federal Reserve should be in no hurry to raise interest rates because there is no serious threat from inflation, at least not now.

According to the US Travel Association and GfK, a market research firm, you might not take a vacation this year. About 40% don't plan on using all of our paid time off. The share of American workers taking vacation is at historic lows. In the 1970s, about 80 percent of workers took a weeklong vacation every year. Now, that share has dropped to a little bit more than half. The declining popularity of vacation has wide-ranging effects not just on workers, but also on their employers and indeed the overall economy. Studies have found that taking fewer vacations is correlated with increased risk of heart disease; other research has shown that workers who take vacations, or even a small break during the workday, are more productive when they return. This vacation aversion is a North American phenomenon; the US is the only “advanced” economy that doesn’t require companies to give paid vacation days.

Housing starts rose to an eight-month high in July. Groundbreaking for new housing jumped 15.7% last month to a seasonally adjusted 1.09-million unit annual pace; this follows 2 straight months of declines. Groundbreaking for single-family homes, the largest part of the market, increased 8.3% in July to a seven-month high. Starts for the multi-family homes segment, such as apartments, jumped 33%.

Home Depot reported quarterly profit today. Profit rose 14% to $2.05 billion. Sales rose 5.7% to $23.8 billion. The number of transactions rose 4.2%. Home Depot said it expects same store sales to grow faster in the second half of the year, as more people take on remodeling projects. However, Home Depot maintained its full-year sales growth forecast of about 4.8%. Lowe's, the world's second-largest home improvement company, is scheduled to report results tomorrow.

Back in 2006 bust, when the housing market went bust, Phoenix was one of the first cities to get hammered with lower prices; in 2011, Phoenix was one of the first cities to snap back; prices, off by nearly 60% from peak, then rebounded sharply; home prices are up nearly 46% from the 2011 low. The number of homes in some stage of foreclosure has fallen to about 4,300 homes today from more than 50,000 four years ago.

Now, prices and sales are cooling off. Inventories of homes listed for sale have climbed to their highest level in three years while the number of houses sold in June fell 12% from a year earlier. Investors accounted for nearly 15% of homes bought in June, down from about one-quarter last year and one-third of sales in June 2012. The market is moving away from from bargain-hunting investors, who typically pay cash for distressed properties, to traditional buyers with mortgages. The Phoenix market is slowly moving back to normal, but there is still a long way to go.

Employment in Phoenix, after expanding at an average annual pace of 2.6% and 2.8% in each of the last two years, is up just 1.5% so far this year. When people don’t have a job or are not secure in their jobs, they don’t buy houses. The sluggish local economy is compounded by consumers still too battered from the bust to think about getting a loan. Some don't have sufficient equity to turn a house sale into an adequate down payment on their next purchase. Others suffered credit blemishes or income hits that make banks reluctant to lend.

Reuters reports Phoenix based PetSmart is exploring a potential sale of the company. Jana Partners, which has reported a 9.8% stake in PetSmart, has been calling on the company to pursue a sale after what it calls years of financial underperformance. There is no guarantee the review will lead to a deal and PetSmart could still determine that it would be better off on its own.

Today marks the ten year anniversary of Google. The company went public August 19, 2004 at a price of $85 a share; and it’s gone up 1,304% since then. A few stocks have done better over that time, but only a few, and of those, only Apple was in the S&P 500 10 years ago when Google went public. Today, Google’s revenue tops $65 billion, more than all but 40 US companies. Net profit margins exceed 20%, higher than all but three. Ten years ago, Google had a forward PE of 52; today, the forward PE is 20. So as share prices have constantly moved higher, valuation has constantly moved lower; which is a neat trick.

Over the past 10 years, or you could say over the past 25 years, a great deal of wealth has flowed to the tech giants of Silicon Valley; which means that the wealth has flowed away from Wall Street. And the techies have finally figured out they don’t need Wall Street bankers to make a deal. According to data from Dealogic, approximately 70% of the tech deals completed in early August have been sealed without a Wall Street bank consultant helping the buyer identify the transaction. And over the past two years, the trend has been growing, with more than half the tech deals in 2012 occurring without a banker working on behalf of the buyer. This M&A consulting shift highlights a subtle but growing divide between fee-eager bankers and the tech giants of today.

Maybe the problem is that the banks just have a hard time remembering who their clients are. Case in point: you may remember the story of Standard Chartered, the British bank, which back in 2012 paid about $667 million to settle charges that it had engaged in money laundering by making transfers for clients in Iran and other countries that were covered by American sanctions. They had to add compliance monitors. A few months later the bank’s chairman denied any wrongdoing, which was a direct violation of the settlement; and he was forced to quickly recant. Today, it seems that all of those new legal staffers and crime-fighting committees also didn’t get the memo about what they are meant to be doing. New York’s financial regulator slapped another $300 million fine on Standard Chartered for “failures to remediate anti-money laundering compliance problems as required” in its previous settlement.

Part of the bank’s 2012 agreement included hosting an independent monitor permanently installed by regulators on-site to vet anti-money laundering procedures. This monitor was back-testing the bank’s processes and found them lacking, particularly when it came to flagging suspicious dollar transfers from its Hong Kong and United Arab Emirates affiliates.

In a statement, Standard Chartered said that it “has already begun extensive remediation efforts and is committed to completing these with utmost urgency.” And this time they really, really mean it; not like last time. So, this raises the question of how many times a bank can break the law, and get away with a slap on the wrist. What does a bank have to do before they forfeit their charter?

The New York State regulator, Benjamin Lawsky, said: “If a bank fails to live up to its commitments, there should be consequences. That is particularly true in an area as serious as anti-money-laundering compliance, which is vital to helping prevent terrorism and vile human rights abuses.”

So, the penalty is nearly $1 billion in fines over the past couple of years, but actually works out to about 12% of bank profits over the same time.

You might also remember last month when Attorney General Eric Holder announced the $7 billion settlement with Citigroup for its role in packaging troubled mortgages into securities and selling them as investments in the years before the crisis, even though a bunch of Citigroup bankers knew better and did it anyway. And last November, there was a settlement with JPMorgan. And there is a chance that later this week we will see a settlement announced with Bank of America.

It all falls in line with the “too big to fail” idea known as the Holder Doctrine, which stems from a 1999 memo, when then Deputy AG Holder included the thought that big financial settlements may be preferable to criminal convictions because a criminal conviction often carries severe unintended consequences, like loss of jobs and the inability to continue as a going concern. Holder was thinking of the collapse of Arthur Anderson after the collapse of Enron. So, now Holder holds to the idea of settlement over prosecutions.  Instead of the truth, we get from the Justice Department a heavily negotiated and sanitized “statement of facts” about what supposedly went wrong.

The problem is, of course, that these settlements allow for the Wall Street bankers to get away with their bad behavior without being held the slightest bit accountable. And with no real deterrent, as Standard Chartered has just confirmed, it’s just a matter of time until they do it all over again. 

Tuesday, July 22, 2014 - Curb Your Enthusiasm

Curb Your Enthusiasm

by Sinclair Noe

DOW + 61 = 17,113
SPX + 9 = 1983
NAS + 31 = 4456
10 YR YLD - .01 = 2.46%
OIL - .17 = 104.42
GOLD – 4.70 = 1308.50
SILV + .04 = 21.07

We start with a couple of economic reports. The National Association of Realtors reports existing home sales were up 2.6% in June to a seasonally adjusted rate of 5.04 million, compared to 4.91 million in May. Sales in June were 2.6% higher than last month, but were 2.3% below the June 2013 rate. Total inventory rose 2.2% in June to 2.3 million existing homes for sale; unsold inventory is up 6.5% from a year ago.

At June’s pace of sales, there was a 5.5 month supply of homes for sale. The Realtors’ group considers a 6-month supply to be a balanced market. Higher supplies favor buyers and lower supplies favor sellers. The Federal Housing Finance Agency says home prices in May rose 0.4% from the prior month and were 5.5% above their level of May 2013. Distressed sales accounted for just 11% of sales in June, down from 15% last year, 25% in 2012, and 30% in 2011. Fewer distressed sales probably explains why there were fewer sales than June of last year.

The Consumer Price Index, or CPI, measures inflation at the retail level; the CPI increased 0.3% in June. The core CPI looks at prices excluding food and energy, which is important for people who don’t eat food or drive cars or use electricity; core CPI was up 0.1% in June. On a year over year basis, CPI is up 2.1%, and the core CPI is up 1.9%. The big driver for the increase in June was higher prices for gasoline.

In earnings reports:

Quarterly profit at McDonald's fell more than expected. Second quarter net income fell almost 1% to $1.3 billion, or $1.40 per share. Sales at McDonald’s restaurants in the US dropped for a third straight quarter.

Coca Cola’s 2Q net income dropped to $2.6 billion from $2.68 billion a year earlier.

Verizon reported second quarter earnings nearly doubled, but it was a confusing report because Verizon paid for Vodaphone shareholders in the quarter, plus they sold some of their wireless spectrum to T-Mobile; cutting through the clutter, Verizon added 1.4 million devices; Verizon added three tablets for every new smartphone. Earnings were just a smidge above expectations.

Comcast reported net income of almost $2 billion for the second quarter, with total revenue of $16.8 billion, up 3.5% from the same period last year. The revenue increase came from high speed internet service. Comcast lost cable video customers, as more people bypass cable and satellite subscriptions in favor of cheaper streaming alternatives.

Credit Suisse reported a second quarter loss of $779 million, the largest loss since 2008; reflecting the charge of $2.6 billion related to the settlement with US law enforcement for a guilty plea to conspiring to aid tax evasion in helping American customers hide money in Swiss accounts. Or another way to look at it, they were one criminal conviction away from a $1 billion quarterly profit. Credit Suisse also announced it would exit the commodities trading business.

Meanwhile, it looks like bond traders are exiting the bond trading business. Trading in US government bonds has dropped 25% in the past few weeks compared to the same time period a year ago. Since the end of the second quarter, trading in investment grade bonds has dropped 17% and trading in junk bonds has dropped 8%.

Last week, Fed Chair Janet Yellen talked about overvaluation in the biotech and social media sectors. One of the most common measures of value is the P/E, or price to earnings ratio; there are certainly other measures of value, but PE is common. Generally, a low PE can point toward value, while a high PE might indicate overvaluation, or even an unprofitable company. Currently the S&P 500 trades at 16.1 times forward 12-month consensus earnings per share. So, you might think a PE of 165 would mean a stock was extremely overvalued, ready to crash; or not. In September 2003, Apple had a PE of 165; since then it has gained about 6,000%.

After the close of trade today, Apple posted fiscal third quarter results. Revenue came in at $37.4 billion versus $38 billion expected; EPS was $1.28 versus $1.23 expected; iPhone sales were on track; iPad sales were a little weak; Mac sales were a little better than expected. Apple posted profit of $7.75 billion, up from $6.9 billion in the year-ago period. Apple announced a new iPhone 6, not yet available, but ready to swamp stores before the end of the year; it will have a bigger screen. Curb your enthusiasm.

Also after the close, Microsoft posted profit of $4.6 billion, or 55 cents a share, on revenue of $23.4 billion. During the year-ago period, the world's largest software company earned $4.97 billion, or 59 cents a share, on $19.9 billion in sales. So, sales were up, profit was a slight miss, due to the Nokia acquisition. Bing search ad revenue is up 40%, and Bing now has about 20% of the market share for search engines. Microsoft is big in the cloud, where revenue is up almost 150%, topping 4 billion.

Hedge fund manager Bill Ackman went on CNBC yesterday and promised he would deliver the death blow against Herbalife. Ackman has been shorting the stock for about a year, a $1 billion bet the company will crash. Then he delivered a 3 hour diatribe with 250 slides in his PowerPoint presentation, alleging that Herbalife is not just a multi-level marketing nutritional club, it is a pyramid scheme preying on minorities, and the biggest fraud since Enron. Ackman didn’t present a great deal of evidence. Today the stock was up 15%, for no apparent reason, other than surviving an Ackman death blow.

There were two rulings from two federal appeals court panels on Obamacare today. The question was whether the government could subsidize health insurance premiums for people in states that use the federal insurance exchange; 36 states use the federal exchange, while the other states set up their own state exchanges. This goes back to wording in the original law that says subsidies can be applied to state exchanges.

 The United States Court of Appeals for the District of Columbia Circuit said that the government could not subsidize insurance for people in states that use the federal exchange. That decision could potentially cut off financial assistance for more than 4.5 million people who were found eligible for subsidized insurance in the federal exchange, or marketplace.

A couple of hours later, the United States Court of Appeals for the Fourth Circuit, in Richmond, upheld the subsidies, saying that a rule issued by the Internal Revenue Service was “a permissible exercise of the agency’s discretion.”

For now, nothing changes, with the exception that there will be many more billable hours for the attorneys.

Bloomberg reports that regulators are ready to label Metlife a potential threat to the financial system, subjecting the insurer to oversight by the Federal Reserve. MetLife, the biggest US life insurer, could be subjected to stricter capital, leverage and liquidity requirements as a result of Fed supervision. A decision by the Financial Stability Oversight Council may come as early as July 31, and MetLife would have 30 days to request a hearing before the FSOC to contest the decision.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is now 4 years old, even though it isn’t really in effect; just 52% of the rules mandated under Dodd-Frank have been finalized by regulators; Another 23% have been proposed but they’re still working out details, and regulators haven’t even gotten around to 24% of the rules. A recent report by consumer watchdog Public Citizen called out the Securities and Exchange Commission as a particularly egregious delayer, noting that it had pushed back the deadlines for 13 of the 23 rules it was supposed to finalize this year.

City workers and retired city workers in Detroit have agreed to pension cuts to help bailout the city from bankruptcy. General retirees would get a 4.5% pension cut and lose annual inflation adjustments. They accepted the changes with 73% of ballots in favor. Support for the pension changes triggers an extraordinary $816 million bailout from the state of Michigan, foundations and the Detroit Institute of Arts. The money would prevent the sale of city-owned art and avoid deeper pension cuts.

Most people travel to or from Israel by air, and the major airport, really the only airport is Ben Gurion in Tel Aviv; last year, 14 million people went through Ben Gurion Airport, in a country with a population of 8 million.  Yesterday a rocket from Gaza landed about one mile from the airport; we don’t have further details on that rocket; it didn’t hit the airport; it was a mile away. When news spread, Delta diverted a flight to Paris. United airlines cancelled flights. The Federal Aviation Administration banned all US passenger and cargo flights to and from Tel Aviv for at least the next 24 hours. European airlines cancelled flight to Israel. The possibility of a passenger jet being shot down over a war zone is a very realistic and fresh memory.

US and United Nations diplomats are in Israel, trying to broker a ceasefire of some sort. Israel continues to pound targets across the Gaza Strip. It does not appear a ceasefire is near. If there is any light at the end of the tunnel, the tunnel will be destroyed.

The European Union today threatened Russia with harsher sanctions if Russia doesn’t cooperate in the investigation of the downing of the Malaysian flight 17 and if Russia doesn’t stop sending weapons to Russian backed separatists in Ukraine. But it was just a threat, and they’ll get together later in the week to draft proposals for sanctions.

Wednesday, July 09, 2014 - Waiting for Liftoff

Waiting for Liftoff
by Sinclair Noe

DOW + 78 = 16,985

SPX + 9 = 1972
NAS + 27 = 4419
10 YR YLD - .02 = 2.54%
OIL – 1.46 = 101.94
GOLD + 7.00 = 1327.60
SILV + .08 = 21.10

The Federal Reserve released the minutes of the most recent FOMC policy meeting from June 17-18.

The Fed is going to take away the punchbowl. As of October, no more punchbowl. That’s it, QE is drying up. I think we all knew that was coming. And then after the Fed stops buying Treasuries and mortgage backed securities, they will get around to probably raising their target on interest rates, but rates would remain near zero for a “considerable time” (probably the spring of 2015) after the Fed halts its program of bond purchases.

According to the minutes, there continues to be division over when the Fed should stop reinvesting proceeds of the $4.2 trillion in assets it purchased to support financial markets. Ending reinvestment will put the central bank's balance sheet on a declining path, and some members argue that should not take place until interest rates have been increased. Fed officials also agreed that the rate of interest on excess reserves would play a “central role” in moving rates higher when the time comes.

And this is a fluid timeline for all this; it is partly dependent on “liftoff”; that’s the new word from the Fed – liftoff. At some point, the economy will slip the surly bonds of earth and wheel, soar, and swing high in the sunlit silence, and do a hundred things we haven’t dreamed of for such a long, long time. Someday, we’ll have liftoff.

The market players looked at the minutes and pulling away the punchbowl, while painful, was an indication of economic strength. Fed officials expressed overall confidence that moderate economic growth will continue and unemployment and inflation will gradually move towards the central bank's targets. A couple of participants noted that consumer spending had been supported importantly by gains in household net worth while income gains had been held back by only modest increases in wages. So, an important element in the economic outlook was a pickup in income, from higher wages as well as ongoing employment gains that would be expected to support a sustained rise in consumer spending. Which is correct in theory; we just haven’t seen the pickup in income.

At the press conference after the June meeting, Fed Chairwoman Janet Yellen said that recent inflation readings were “noisy.” According to the minutes, the Fed staff was not concerned with inflation despite some recent higher readings. Although the Fed staff revised its inflation forecast up “a little” in the near term, the medium term projection was revised down slightly.

Yesterday I talked about an anomaly in the jobs number from Thursday. How could we have negative 2.9% GDP in the first quarter while we were adding all those jobs? I concluded that the problem was that productivity was declining.

New data was released this morning showing US productivity growth was the worst since the recession. The data from the Labor Department looks at multifactor productivity, and it includes the impact of capital, new machines, investment in technology, and such. The measure of capital services input grew 1.9%, which is the best showing since 2008, but that is more a reflection of the bounce from the 1st quarter, and still far from the pre-recession levels that were consistently above 3%. So, the data in this morning’s report is consistent with an economy coming out of a recession but nowhere near its pre-recession rate of growth. Bottom line is that productivity needs to increase if the economy is going to get better.

One of the concerns for Fed monetary policy is inflation, which isn’t a problem right now and when we have seen a problem in the past 20 years of so, the Fed has been able to tamp it down. The problems with inflation right now are tied to energy and food prices. Food prices are largely tied to weather, and we have seen some nasty weather, and the Fed can’t control the weather. Extreme weather will be an ongoing problem, and rising food prices will be an ongoing challenge, but for now, it’s a short term inflation problem.

Energy prices are largely tied to geopolitical problems in the Middle East. Iraq, Israel, Syria, and other problems could explode out of control at any given moment, but we’ve seen crude oil prices dropping for 9 sessions. The problem in Iraq may very well result in the country splitting apart, but the southern regions, which produce and export the most oil, will likely continue exporting oil. So, the oil traders don’t seem concerned about Iraq divided in 3 parts. Meanwhile, Ukraine hasn’t unfolded as Putin planned. Kiev did not roll over. Sanctions are painful. Putin doesn’t look like he wants to escalate the fight; at least not today.

Meanwhile, the US is more or less on track to pass Russia and Saudi Arabia as the world’s largest producer of crude oil within the next 5 years. Domestic crude output is increasing but the increase is coming from shale and shale is notoriously tricky and expensive to extract. The US will continue to extract more shale oil but certain projects, even mega-projects, have been abandoned because of the expense. We know that there are huge reserves in the US, but it doesn’t always pay to pump it; so the increase in output may not be as strong as hoped. For now, prices are high and oil extraction is soaring at shale formations from Texas to North Dakota as companies split apart rocks using high-pressure liquid, or fracking. The result is that now Oklahoma has more earthquakes than California, and we are less dependent on foreign oil.

The United States has just become the world’s biggest oil producer, at least when you consider crude oil plus natural gas together. The US has been the top global nat gas producer for the past 4 years, but a new report from Bank of America says that in the first six months of this year the US overtook Saudi Arabia and Russia to become the top producer of petroleum product, that is oil and natural gas and the liquids that are separated from nat gas.

Annual investment in oil and gas in the US is at a record $200 billion, reaching 20% of the country’s total private fixed-structure spending for the first time, but it will take some time for that investment to work its way through the rest of the economy. We now produce about 11 million barrels a day of crude oil and we consume about 18.5 million barrels a day. So despite the boom, we still import oil and we are still dependent on OPEC. If we converted from oil and gasoline to nat gas, starting running more cars on compressed natural gas, we could become energy independent in short order.

The other side of the equation remains conservation and not just a switch to nat gas but a switch to renewable energy. You think green energy is too expensive? Tosh; tosh and falderal. Global energy markets are reaching a tipping point. For the first time, a large fraction of the world's fossil fuels could be replaced at a lower cost by clean energy, with today's renewable technologies and prices. And virtually no further investments in fossil fuels make long-term economic sense because higher fossil fuel prices over their useful life will be exorbitant.

Barclay's Bank recently downgraded the entire US utility sector in fear that it would not respond to the disruptive challenge of distributed solar. The Barclays credit team believes that, over the next few years, the “confluence of declining cost trends in distributed solar photovoltaic (PV) power generation and residential-scale power storage is likely to disrupt the status quo.” The new government in India is cutting fossil fuel subsidies and promising to provide rooftop solar for 400 million homes. Conservation is another important element. Profitable building retrofits would cut fossil fuel used for heating and cooling by 20%, and displace another 15% of fossil fuel electricity demand.

International oil companies are hitting the wall on the price they will pay for big new oil projects. There is plenty of oil in Ohio but BP, in its last quarterly report, announced it would halt development of the Utica shale fields. Along with BP, Chevron, Shell, Total, Statoil, and Exxon have all cancelled or delayed mega projects or even sold off major investments in US oil projects

The latest Bloomberg New Energy Finance projection suggests that 2/3 of incremental global power generation over the next fifteen years will come from renewables. Declines in coal use in developed economies will be sharp enough to cut the global share of fossil fuels from 64% today to only 44% in 2030.

Electricity currently provides only 1% of global transportation energy; EV's and rail could today replace the first 15% of the oil used by cars and trucks at with an internal rate of return higher than 15%. Fossil fuels generate 63% of the world's power, renewables less than 5%, but 1/3 of fossil electricity now costs more than competing wind and solar. And that doesn’t even begin to factor in the externalities associated with fossil fuels.

A couple of quick notes as we wrap up. Citigroup is reportedly close to paying about $7 billion to resolve a probe into whether it defrauded investors on billions of dollars’ worth of mortgage securities in the run-up to the financial crisis. A majority of the settlement is expected to be in cash, but the figure also includes several billion dollars in help to struggling borrowers. An announcement of the settlement between the bank and the Department of Justice could come as early as next week.

This bit of economic data came in late this afternoon. The Arizona Regional Multiple Listing Service shows the Phoenix market saw overall sales in June drop 11% year over year; now back to the lowest sales since 2008. Non-cash sales were up 6% year over year, but cash sales were down 40%; so it looks like investors are moving on. Active inventory is up 43% year over year and at the highest level for June since 2011. So, sales are down, inventory is very high, and cash is scarce.

When do we start QE4?

Friday, June 20, 2014 - Wall Street’s Midsummer Night’s Dream

Wall Street’s Midsummer Night’s Dream

by Sinclair Noe

DOW + 25 = 16,947
SPX + 3 = 1962
NAS + 8 = 4368
10 YR YLD un = 2.62%
OIL + .83 = 107.26
GOLD – 5.60 = 1315.70
SILV + .12 = 20.98

Both the Dow and the S&P closed at new records, with the Dow hitting an intraday high of 16,978. For the week, the Dow was up about 1 percent, the S&P 500 was up 1.4 percent and the Nasdaq was up 1.3 percent.

Today is the last day of spring. The solstice will occur tomorrow morning at 6:51 AM Eastern time, so tomorrow is technically the first day of summer, and the longest day of the year, or at least the day with the most daylight. For the western states, we’ll have solstice at 3:51AM, so there really will be some Midsummer Night’s Dreams. The markets have been drifting in and out of fantasy and reality this week.

On Wednesday, Federal Reserve Chairwoman Janet Yellen said the Fed would keep doing what the Fed does, and all the markets heard “buy, buy, buy.” Wall Street traders opened their eyes from a Midsummer Night’s Dream and fell in love with the first trade they saw.

Yellen said inflation was just “noisy” and interest rates could stay "well below longer-run normal values at the end of 2016." Yellen nonetheless cited reasons for optimism about the economy, including resilient household spending and an improving jobs market, even as the Fed lowered some of its economic forecasts. This is a recurring theme. The Fed’s forecasts for economic growth in 2014 have resembled a downward slope. They cut their forecast on Wednesday from the range of 2.8% - 3.0% down to 2.1% -2.3%. Back at the start of 2012, the Fed thought this year, we would see 4% growth. At the start of this year, they expected 3.5% growth.

Meanwhile, the IMF is warning government officials around the world to prepare for the time when the Fed and other advanced economy central banks do raise interest rates. Not that rates will rise soon or fast, but eventually they will rise, and the IMF hopes to prolong that time, even if it risks fueling asset price bubbles. The long lead time before Fed rate increases should give governments around the world more time to get their economic houses in order. However, it also may encourage undisciplined governments to put off reforms. The IMF believes disruptive market volatility is one of the biggest risks in the years ahead.

And then there’s the question of how the Fed will actually exit QE. At the beginning of 2007 the Fed held assets totaling about $880 billion. Today, the balance sheet stands at about $4.3 trillion, including $2.4 trillion in treasuries and $1.7 trillion in mortgage backed securities. This was the Fed’s attempt to drive down actual rates on actual loans to people and businesses, with the idea that lower rates would stimulate demand. The Fed can set a target for the Fed funds rate, but that’s just a target.

Anyway, all those bond purchases worked, sort of; long term rates dropped relative to short term rates and risky obligations. The best guess is that long term interest rates dropped about 25 basis points for every $600 billion in bond purchases. And buying mortgage backed securities helped push down mortgage rates, which was helpful in putting a floor under housing prices, and likely spurred some construction, although the housing market seems to be stalled right now.

The Mortgage Bankers Association yesterday lowered its forecast for combined new and existing home sales in 2014 to 5.28 million; a decline of 4.1% that would be the first annual drop in four years. The group also cut its prediction on mortgage lending volume for purchases to $595 billion, an 8.7% decrease and the first retreat in three years. The big housing rally wiped itself out because prices increased too quickly for buyers to keep up. The pool of eligible new buyers is collapsing because of stagnant incomes and lack of credit. This revealed one of the biggest problems for the Fed’s stimulus plan; they could indeed lower rates, but they couldn’t direct distribution.

Could the Fed get back to pre-crisis balance sheets? Probably not, but they can just hold the bonds to maturity. There really doesn’t seem to be any viable option, and if the Fed continues to hold those securities, it’s a safe bet they won’t be trying to push rates too high too fast. At the same time, however, the Fed reinvests billions of dollars from maturing securities, about $16 billion each month this year, to maintain the size of its holdings.

The Fed once planned to stop reinvesting, allowing its holdings to dwindle, soon after it ended the expansion of the portfolio. In 2011, the Fed said this would be its first signal that it was winding down the stimulus campaign. But there is growing support among Fed officials to preserve the portfolio’s size instead.

Fed officials generally argue that the effect of bond buying on the economy is determined by the Fed’s total holdings, not its monthly purchases. In this view, reinvestment would preserve the effect of the stimulus campaign. Not everyone agrees with this assessment; some people believe the flow of funds is more important than the size of the balance sheet. The Fed in recent years has almost completely replaced its inventory of short-term government debt with longer-term securities that do not begin to mature until 2016.

And the composition of the balance sheet means that the Fed will have a whole bunch of paper maturing in early 2016. What they do then will be important. Reinvesting will have a fairly significant jolt for the economy. Many in the Fed have come to accept the bond holdings as a fact of life. In 2011, when the Fed first described its exit plans officials believed that reducing the Fed’s bond holdings was a necessary step to maintain control of inflation. Maybe that’s why Yellen can dismiss inflation as being nothing more than noise. So, even as the Fed reduces purchases, the overall balance sheet remains large, and reinvestments will be significant, and their feeling is that raising the target on interest rates will only provide flexibility with monetary policy.

It all sounds good on paper, but I still think the process will be a bit painful, with unintended consequences.

Let’s get you up to date on the situation in Iraq. Ayatollah Ali al-Sistani, an Iraq cleric considered one of Shia Islam's leading voices, has called for creation of new government that avoids past mistakes; so it looks like prime Minister Maliki is in trouble. Sistani called for national unity. The Pentagon says it has seen evidence of "small numbers" of Iranian troops in Iraq but no sign of a major deployment by Tehran.

Obama said yesterday he was prepared to send up to 300 military advisers to help the Iraqi security forces. The special forces troops will work in teams of around 12 and be based mainly at the headquarters of the Iraqi military, with some deployed to individual brigades. The Pentagon said today that the first couple of teams will be made up US troops already in Iraq at the embassy but that as of now no additional units had been sent.

UN Secretary General Ban Ki-moon has effectively endorsed Barack Obama's decision to hold off from ordering air strikes in Iraq, saying that any such action would likely be futile or could even backfire: "Military strikes against ISIS might have little lasting effect or even be counter-productive if there is no movement towards inclusive government in Iraq."

The oil refinery in Baiji, in the north of Iraq, has reportedly fallen to the ISIS rebels. And fighting continues, with most of the battles being won by the rebels. If you are still unclear about the events on the ground in Iraq, you are not alone. According to a Newsweek report, US intelligence has lost virtually all its local assets to be left effectively blind in the country:

“The “surprising” collapse of the Iraqi army and the defection of key Sunni tribal leaders to al-Qaeda-inspired insurgents has largely stripped the CIA of spies in … country. As a result, according to a US intelligence official, the CIA is mostly relying on “technical means”—electronic intercepts of all kinds—and the support of friendly regional secret services, like Jordan’s, to monitor the rapidly deteriorating situation.

Oil prices have inched up but not as much as some feared they would, considering that Iraq is the second largest producer in OPEC. If its supply was completely disrupted, it would take all of the world’s surplus production capacity to replace it.

Gasoline prices typically fall in the weeks following Memorial Day, after supplies increase enough to fill up the cars of the nation's vacationers as summer approaches. This year, drivers are paying more. The national average price of $3.67 a gallon is the highest price for this time of year since 2008, the year gasoline hit its all-time high.

Tuesday, June 17, 2014 - What Could Go Wrong?

What Could Go Wrong?
by Sinclair Noe

DOW + 27 = 16,808
SPX + 4 = 1941
NAS + 16 = 4337
10 YR YLD + .06 = 2.65%
OIL - .30 = 106.60
GOLD un = 1272.70
SILV + .09 = 19.86

The FOMC, the Federal Open Market Committee started two days of meetings today; tomorrow they are expected to announce more of the same. The FOMC is largely expected to taper its asset purchase program by $10 billion to $35 billion. Effective July 1, the Fed is expected to lower its asset purchases to $15 billion in agency mortgage backed securities (MBS) and $20 billion in Treasuries. The Fed is also expected to maintain its current forward guidance language on federal funds rate support; in other words, they will keep telling us that rates might increase sometime next year.

The committee is likely to make some upgrades to its description of the economic outlook in its economic projections. The committee will probably need to reduce its 2014 real GDP growth forecast to take into account the Q1 disappointment, and we can probably expect the committee to reduce its unemployment rate forecast and lift its inflation forecast slightly.

The consumer-price index climbed a seasonally adjusted 0.4% in May from a month earlier. It marked the fastest increase since February 2013 and doubled the pace of economists' forecasts. Excluding food and energy components, so-called core prices increased 0.3%, the fastest pace since August 2011. From a year earlier, core prices were up 2%, the most since February 2013, and now match the Fed's target.

Another inflation measure closely watched by the Fed, the core personal-consumption expenditure, has stayed far below 2%. Inflation at wholesale level unexpectedly dropped by 0.1% in May, but remember the PPI rose 0.6% in April, so this is just a leveling out process. Wage pressure remains stubbornly low and consequently, the pace of the economic growth remains uneven. In May, the real average hourly wage fell 0.2%. Real wages have fallen three straight months even as inflation has picked up slightly.

The average hourly wage for a typical American worker registered just $10.28 in May, adjusted for inflation and measured in constant dollars. The real hourly wage totaled $10.31 in June 2009, the last month of the 2007-2009 recession. This is part of a trend that stretches back about 30 years.

Still, with core prices up 2% on an annual basis, the Fed will need to address the topic of inflation tomorrow. Let’s hope they also mention the lack of wage gains.

Another report today shows housing starts posted a bigger-than-forecast 6.5% decline. Housing starts declined to an annual rate of 1 million units last month from 1.07 million in April. What’s more, permits for new construction fell by 6.4% in May to a 991,000 annual pace, the slowest in fourth months.

The situation in Iraq is still bad. The ISIS rebels are about 40 miles north of Baghdad and seem intent on the idea of attacking the capitol city. Or they might attack the major source of revenue for the ruling government, and that means oil. One of three major oil refineries has now fallen under control of ISIS; the other two are in Baghdad and the south and not considered to be threatened at this time. About 2.5 million barrels of oil a day are exported from Basra, Iraq’s main port, located in the south.

The world consumes about 92 million barrels a day, so that would be a major disruption, and it would not be surprising to see prices jump; with price levels increasing along with the severity of the given scenario, running anywhere from a few dollars per barrel to a worst case of $200 a barrel.

Not too long ago, Iraq was claiming that it would be producing 12 million barrels a day by 2017. That now seems a little too optimistic.  At best, the ISIS rebellion guarantees that any potential additional Iraqi oil output gains are not going to materialize in the near future. No oil companies are going to invest in Iraq until and unless the situation stabilizes.

Although the consequences for Iraqi oil production of what has happened so far appear to be minimal, all this comes at a time when the earlier and still ongoing conflicts in Libya and Syria have already disrupted nearly 2 million barrels a day in world oil production. If Iraq’s recent 3 million barrels a day was also taken out, we would be talking about a significant disruption in world oil supplies, and likely an oil price in excess of $150 a barrel.

The worst case scenario sees a regional conflict break out that pits the Middle East’s Shiites (Iran) against the Sunnis (Saudi Arabia), leading to a compromise of the Strait of Hormuz. Forty percent of the world’s exported oil is transported through this waterway.

And if that isn’t enough, focus you attention on Ukraine. Yesterday, Russia announced it was cutting off natural gas shipments to Ukraine; today an explosion destroyed one of Ukraine’s main pipelines for gas headed to Western Europe.

EU-brokered talks failed to reach a compromise between the countries, which remain far apart on a “fair” price for gas. Ukraine’s state-run gas operator filed a suit in an international arbitration court, claiming $6 billion in overpayment for gas since 2010. Its Russian counterpart filed a suit of its own, alleging unpaid debts worth $4.5 billion on gas delivered since 2009. Until these cases are resolved, Ukraine will receive only gas it pays for upfront, and must not impede the flow of gas destined for the EU, which gets around 15% of its gas via pipelines that pass through Ukraine. There is another pipeline running from Russia directly to Germany, but still, the global energy picture looks less and less stable.

On Friday we reported that Tesla, the electric car company started by Elon Musk, was freeing up its patents, making its technology available to competitors. Now Nissan and BMW are considering negotiations for cooperation on charging networks; basically using and enlarging Tesla’s existing network of 97 charging stations in the US. Nissan already produces the electric Leaf and BMW last week unveiled the electric i8 in Germany.

So, why design new chargers and invest in building a whole new infrastructure for BMW and Nissan drivers? The Tesla network already stretches from coast to coast and is expected to expand rapidly over the next year. And Tesla leads in battery technology, with a gigafactory planned to start production in 5 years, which will be the biggest battery making facility in the world, producing 500,000 lithium-ion battery packs per year; more than enough for Tesla and its competition.

SolarCity, the largest US installer of residential solar panels whose largest shareholder is entrepreneur Elon Musk, announced that it plans to acquire solar panel maker Silevo and expand into manufacturing with new panel factories, likely including the world’s largest high efficiency solar panel plants in New York. At a conference call announcing the move, Musk said: "We expect to have to install 10 gigawatts [of high-efficiency panels] a year. If you look at the current capacity in the world, we're not able to do that right now."

It's not just a supply question. Solar panel prices have been falling in recent years thanks to a production boom in China; and the panels getting produced, though cheap, aren't terribly efficient and prices have begun bottoming out anyway. Prices might start climbing soon. Government subsidies for renewables start getting phased out in 2016, and the political environment for rebooting subsidies remains unstable at best. Plus, recent moves by the US to slap tariffs on Chinese panels likely served as a catalyst for looking into building the Silevo plant.

According to a study by two professors at the Stern School of Business at New York University and one professor from McGill University, a quarter of all public company deals may involve some kind of insider trading. The professors examined stock option movements, when an investor buys an option to acquire a stock in the future at a set price, as a way of determining whether unusual activity took place in the 30 days before a deal’s announcement. They determined statistically that the odds of the trading “arising out of chance” were “about three in a trillion.” [...] But, the professors conclude, the Securities and Exchange Commission litigated only “about 4.7 percent of the 1,859 M&A deals included in the sample.”

The study also says: “While the SEC has taken action in several cases where the evidence was overwhelming, one can assume that there are many more cases that go undetected, or where the evidence is not as clear-cut, in a legal/regulatory sense.” Plus another finding from the abstract: “Historically, the SEC has been more likely to investigate cases where the acquirer is headquartered outside the US.”

A new survey by Greenberg Quinlan Rosner, on behalf of Better Markets, finds voters regard Wall Street and big banks as “bad actors. A 64% majority believes the “stock market is rigged for insiders and people who know how to manipulate the system. Another 55% believes “Wall Street and big banks hurt everyday Americans by pouring money into ’get rich quick schemes’ rather than real businesses and investments. A 60% majority favors “stricter regulation on the way banks and other financial institutions conduct their business” and just 28% oppose. Support for stricter regulations inspires bipartisan support; most notably voters who own stocks are more likely to support stricter regulation than voters overall. And there is urgency in the issue because 83% of voters believe another crash is likely in the next 10 years.

Tuesday, April 15, 2014 - Yellen in the Lions' Den

Yellen in the Lions' Den
by Sinclair Noe

DOW + 89 = 16,262
SPX + 12 = 1842
NAS + 11 = 4034
10 YR YLD - .01 = 2.62%
OIL - .22 = 103.83
GOLD – 24.20 = 1303.40
SILV - .41 = 19.66

Stocks were all over the place today. We started with triple digit gains for the Dow Industrials, dipped to triple digit losses, then back into positive territory for the close with the major indices closing just below their morning highs. This kind of volatility does not engender confidence; it does warrant caution.

The utilities sector gained 1.3% and finished ahead of the other groups, extending its YTD gain to 11.8%; the biotech ETF added 1%, while the broader healthcare sector advanced 1.1%.Tech stocks have been beaten up quite a bit over the past couple of weeks. The Nasdaq 100 Tech Index (NDXT) is down 7% since April 1st. The Nasdaq Composite has exhibited weakness, but not to the point of meeting the definition of a correction; it would take a slide to 3,922 to mark a 10% fall from the March 5 closing high at 4,357; a 10% pullback from the March 6 intraday high of 4,371 would be achieved at 3,934.

The Labor Department’s Consumer Price Index, or CPI, increased 0.2% in March after posting a 0.1% increase in February. Excluding volatile food and energy prices, core prices ticked up 0.2%.Prices rose 1.5% for the 12 months ending in March. That is up from February’s year-over-year reading of 1.1%. Core prices moved up 1.7% over the 12 months, up from 1.6% in February.

A major factor in both headline and core CPI in March was a 0.3% increase in shelter costs. On an annual basis, housing costs were up 2.7%, the fastest pace in six years. The indexes for medical care, used cars and airline fares also increased in March. Apparel prices rose for the first time this year. Household furnishings and recreation prices dipped in the month. Real or inflation-adjusted hourly wages, meanwhile, fell 0.3% in March to $10.31. Real wages have risen 0.5% over the past 12 months. So, we’re not seeing wage-push inflation.

The big difference has been housing; shelter costs account for a full third of the basket of goods and services tracked in the consumer price index. In the past year, consumer prices excluding shelter have risen just 1%, an indication that inflation pressures are subdued outside of housing.

The old rule of thumb was that rents and utilities combined should not take up more than 30% of household income. A new study by Zillow finds 90 cities where the median rent, not including utilities, was more than 30 percent of the median gross income. A study by Harvard finds that nationally, half of all renters are now spending more than 30% of their income on housing, up from 38% of renters in 2000. Part of the reason for the squeeze on renters is simple demand; between 2007 and 2013 the United States added, on net, about 6.2 million tenants, compared with 208,000 homeowners.

For many middle and lower income people, high rents choke spending on other goods and services, impeding the economic recovery. Low-income families that spend more than half their income on housing spend about a third less on food, 50% less on clothing, and 80% less on medical care compared with low-income families with affordable rents.

Federal Reserve Chairwoman Janet Yellen is scheduled to go to the lion’s den tomorrow, making a speech before the Economic Club in New York. Today, Yellen took the show on the road, speaking to a banking conference in Atlanta, she said current rules on how much capital banks must hold to protect against losses don't address all threats. She said the Fed's staff is considering what further measures might be needed, and such measures would likely apply to only the largest and most complex banks. Yellen said the Fed would review the likely effects of imposing stricter rules on banks. That probably plays better in Atlanta than Manhattan.

At some point Yellen must press the case of the Fed as regulator and in control of the banks rather than vice versa. Now, any threat or hint of threat at tighter control is only likely to result in the big banks moving risky behavior into less regulated areas of the financial system. These areas are often called the shadow banking system.

One area of concern for Yellen and her Fed colleagues is the short-term debt markets. So, Yellen would like to see the banks hold more capital; the idea being that it would make them less susceptible to a run. Now, when you hear that the Fed Chair is concerned about a bank run, this is not the old fashioned bank run, with customers lined up at the door of Bedford Savings and Loan and Jimmy Stewart trying to persuade his neighbors that their long-term loans will provide sufficient liquidity to short-term needs.

The problem goes to an area of regulation overlooked, or perhaps neglected by Congress and the various regulators; specifically derivatives; and after the collapse in 2008 what the regulators did was to concentrate the risk of the derivatives among four major Wall Street banks; the big banks just got bigger.

If you’ve ever stood in a teller’s line at the bank, you may have noticed the FDIC sticker, which reads, “Backed by the full faith and credit of the United States Government.” Effectively, that means, if the assessments the FDIC charges the banks to meet the needs of the Deposit Insurance Fund run short, the taxpayer must prop up the fund to make insured depositors whole. On top of that promise, the National Depositor Preference statute came into being in the US in 1993, making all deposit liabilities at insured depository banks preferred over the claims of other creditors.

The serious wrinkle in the plan is that if one of the four largest banks in terms of derivative exposure was put into receivership by the FDIC, its derivative counterparties have the legal right to assert a super-priority claim on the liquid assets of the bank, jumping in front of depositors. Typically, the counterparties start grabbing their collateral before the public is even aware of the problem.

The Deposit Insurance Fund probably has about $40 billion in assets. With the Dodd-Frank prohibition against further taxpayer bailouts of banks, where would the FDIC turn to stem a run on one of the largest banks?

Under the Federal Deposit Insurance Act, the FDIC, acting as a conservator or receiver for an insured depository institution, has the right to “disaffirm or repudiate any contract or lease.” But here again, Wall Street has the FDIC between a rock and a hard place. Let’s say there was a reenactment of 2008 and Citigroup was sliding toward insolvency. If the FDIC repudiated Citigroup’s derivative contracts, it would set off a panic and contagion at the other three largest banks holding trillions in derivatives, creating an even larger financial tab for the Deposit Insurance Fund to meet. Banks taking deposits of public funds are required to pledge collateral against any funds exceeding the deposit insurance limit of $250,000. But derivative claims are also secured with collateral, and they have super-priority over all other claimants, including other secured creditors. The money is gone before you get to the teller’s window.

But before you lose any sleep over the prospects of another, potentially far worse global financial meltdown, take solace that the economy is recovering. There are a few more jobs, and consumers are spending, and the housing market is improving, and the Fed has been pumping money into the economy to foster this growth of credit. Right?

Well, one of the lessons we’ve learned in the recovery is that there is a difference between credit growth and economic growth. And absent real and sustainable economic growth a gap eventually forms as credit growth expands. The more one spends on a place of shelter the less one has to spend on other things, and overall demand is reduced. Bank lending finances the purchase of existing assets, particularly with reference to real estate. Such existing asset finance does not directly stimulate investment or consumption, but it drives up asset prices, and that leads lenders and borrowers to believe that even more credit is both safe and desirable. The expansion is like a rubber band that can only stretch so far.

So, it seems the greatest danger to the current economy are the very mechanisms that are still used to “fix” the last financial crisis: money-printing and asset-purchases by major central banks around the world that unleashed a global flood of liquidity for over five years. Most of this massively huge pile of cash has landed in the laps of banks, institutional investors, hedge funds, private equity firms, and other speculators has not been used to boost lending to the private, and thus has not contributed to the recovery of the real economy. Instead, it has been poured into financial assets and has artificially goosed their valuations.

This money sloshing through the system and the persistence of zero-interest-rate policies have driven desperate investors ever further out into “all risky asset classes,” including emerging assets, junk-rated corporate credit, Eurozone peripheral debt, and equities. That buying pressure has inflated their valuations even further. And in the emerging markets, it led to an appreciation of exchange rates.

And when the rubber band breaks, there will be a derivatives bet on it. When the derivatives default, the counterparties, operating in an unregulated shadow banking world of their own design, do not have sufficient capital to pay off the derivatives bet, and so the first thing they’ll do is raid the bank vaults, and when that dries up, the short-term credit markets freeze, because none of the counterparties have faith that the other party has any more in capital reserves than they have.

Wednesday, March 19, 2014 - Behind the Curtain of the Mysterious Central Bankers

Behind the Curtain of the Mysterious Central Bankers

by Sinclair Noe

DOW – 114 = 16,222
SPX – 11 = 1860
NAS – 25 = 4307
10 YR YLD + .09 = 2.77%
OIL + .67 = 100.37
GOLD – 24.90 = 1331.60
SILV - .20 = 20.71

Sometimes the stock market is a grand mystery, a riddle wrapped in a mystery inside an enigma. Sometimes the stock market is simple. Wall Street loves it when the Federal Reserve is throwing bags of money out of the helicopter that hovers over Wall Street. The traders get a little nervous when it looks like the free money might stop raining down on them. That doesn’t mean the Fed is stopping throwing money at Wall Street, just that traders are nervous.

Today, the Fed FOMC wrapped up a two day meeting; they issued a statement; then Chairwoman Janet Yellen delivered a prepared statement; then she answered questions.

The Fed statement indicated the Fed could and likely would continue with its low interest rate policy even after they reach their goals of full employment and 2% inflation. The central bank proceeded with its well-telegraphed reductions to its massive bond-buying stimulus, announcing it would cut its monthly purchases of Treasuries and mortgage-backed securities to $55 billion from $65 billion per month.

I will now attempt to translate the Fed statement from Fedspeak to English. The statement said: the labor market is getting better but unemployment is still too high, household and business spending is decent but the housing market is weak, the politicians in Washington keep messing up the economy but they haven’t been adding on new mistakes lately so we should be able to work around them, inflation is too low and that might cause problems, even as they cut purchases to $25 billion a month in mortgage backed securities and $30 billion a month in Treasuries – that is still a heck of a lot of paper they are buying, the Fed analysts will keep an eye on economic conditions and at some point they will raise rates but not today and not based on a 6.5% target for unemployment, and the analysts think the economy is better than the  public thinks, and the only reason the economy is so bad is because the weather has just been horrible this winter.

Then, Janet Yellen held a press conference. Back in December the Fed forecasts called for unemployment falling to between 5.8% and 6.1% by the fourth quarter of 2015. The new forecasts show Fed officials see unemployment dropping slightly faster, to between 5.6% and 5.9% by the end of 2015. So, that ratchets up forward guidance on rates. Fed officials see slightly sharper increases than they did in December, with rates ending 2015 at 1% and ending 2016 at 2.25%, according to the median of forecasts. In December, Fed officials expected short-term rates to be just 1.75% by the end of 2016. Of course, that’s all dependent on economic data over the next year or more, and we could have another unexpected snowstorm or 2 or 20, but it was enough to make Wall Street traders nervous that the Federal Reserve won’t always provide a super low interest rate subsidy to the bankers.

The nervousness only grew as Yellen entered the Question and Answer phase of the press conference. She was asked how long the Fed would wait after the tapering ends before it begins to raise interest rates. She answered: “So the language that we used in the statement is ‘considerable period.’ So I, you know, this is the kind of term it’s hard to define. But, you know, probably means something on the order of around six months, that type of thing.”

So, let’s do the math. The Fed continues to taper asset purchases by $10 billion a month; announcing incremental cuts at each of the next 6 FOMC meetings; so maybe around October, they finish the buying; then 6 months pass and now we’re looking at April 2015, which is more or less when everybody knew the Fed might start to consider raising rates, if everything goes according to plan…, and we don’t have any more surprise snow storms.

And that is a big change for trying to figure out when the Fed will raise rates. It’s no more quantitative easing, based on a hard, quantitative number like 6.5% unemployment rate. Now the Wall Street traders actually have to look at the economy and try to guess the qualitative factors. Translation: the Fed is looking at when the economy improves, and the economy comprises a giant number of measures and statistics. If Wall Street wants Cliffs Notes, it will have to look elsewhere.

Interest rates matter to the Wall Street traders because it determines the profits for the Wall Street banks that trade Treasuries and mortgages and such, and they want the data spoon fed, kind of like the kid taking a test with an open book.

Part of the problem with the old 6.5% rule was that the unemployment rate didn’t do a good job of measuring the real employment picture; the unemployment rate was dropping, getting close to the 6.5% target, but that’s because more people were dropping out of the workforce. The unemployment rate only measures people who are still in the workforce and can’t find jobs; it ignores those who have given up.

Yellen just ended the “open book” testing. No longer will the Fed promise to raise interest rates at 6.5% unemployment. Instead, the Fed will raise interest rates when the economy is strong enough to justify it. Wall Street will have to actually pay more attention to the strength of the economy than they pay to filling out their basketball brackets.

Telling Wall Street traders to think is tricky business; they don’t think, they trade. The Fed, under Yellen, wants to keep market expectations aligned with their own forecasts. If traders start to price in earlier rate hikes, the result would be tighter financial conditions that could deter the very investment and hiring that the Fed wants to promote.

The only thing traders heard today was “around six months”. Did Yellen mean to be that specific? No, the Fed has always loosely defined “considerable period” as about half a year. It’s supposed to be a little vague. She probably didn’t intend to give any hints about timing beyond what the “dot plot” said. No Fed chair is going to confidently tell markets that it’s going to raise rates in 14 months. But now that she’s leading the Fed, the markets will react to what she said, not what she means. And this is where it gets interesting. Will Yellen and her Fed colleagues try to “walk back” her statements, or will they leave them out there as they stand. It could be a defining moment in the early stages of the Yellen-led Fed.

Meanwhile, there are some new definitions in on central banks role in the process of printing money, and that came from the Bank of England a few days ago. In a paper called “Money Creation in the Modern Economy”  co-authored by 3 economists on behalf of the  Bank of England, they state that most common assumptions of how banking works are simply wrong, and the entire theoretical basis for austerity is wrong.

Consider the old, conventional view, which continues to be the basis of most of the debate on public policy and the framework for austerity. People put their money in banks. Banks then lend that money out at interest – either to consumers, or to entrepreneurs willing to invest it in some profitable enterprise. True, the fractional reserve system does allow banks to lend out considerably more than they hold in reserve, and true, if savings don't suffice, private banks can seek to borrow more from the central bank.

The central bank can print as much money as it wishes. But it is also careful not to print too much. In fact, we are often told this is why independent central banks exist in the first place. If governments could print money themselves, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Institutions such as the Bank of England or US Federal Reserve were created to carefully regulate the money supply to prevent inflation.

Under this old, conventional definition, money is a finite resource; there are limits. What the Bank of England admitted this week is that none of this is really true. To quote from its own initial summary: "Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits" … "In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money 'multiplied up' into more loans and deposits."

In other words, everything we know is not just wrong – it's backwards. When banks make loans, they create money. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognize as legal tender by its willingness to accept them in payment of taxes. There's really no limit on how much banks could create, provided they can find someone willing to borrow it.

What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. Government spending is the main driver in all this. So, there's no question of public spending "crowding out" private investment. It's exactly the opposite.

Some of us have known this for quite some time, but this was the first time a major central bank has admitted it. Why did they admit it? Probably because that whole austerity thing hasn’t been working out.

Tuesday, March 18, 2014 - Food and Oil

Food and Oil

by Sinclair Noe

DOW + 88 = 16,336
SPX + 13 = 1872
NAS + 53 = 4333
10 YR YLD - .02 = 2.68%
OIL + 1.62 = 99.70
GOLD – 12.00 = 1356.50
SILV - .38 = 20.92

Let’s start with some economic news. The National Association of Home Builders housing market index increased to 47 in March, up from 46 in February. A reading below 50 means more builders view conditions as poor rather than good. Fewer homes are being started in early 2014 than at the end of 2013. Housing starts came in just slightly below economists’ expectations of 910,000 at 907,000.

Separately, a quarterly survey by the Business Roundtable found US chief executive officers somewhat more positive about the economy, including plans for hiring and capital spending over the next six months; they expect gross domestic product to advance 2.4% this year. The forecast is a slight upgrade from an expectation of 2.2% in the previous survey but still less than robust.

The Consumer Price Index, or CPI, increased a seasonally adjusted 0.1% in February, matching the increase in January. According to the Labor Department report, the increase was mainly due to higher prices for food. Energy prices decreased 0.5%. Over the last 12 months, the CPI is up 1.1%. Costs for meats, poultry, fish, dairy and eggs drove the gains. Most notably, beef and veal prices surged.

Prices for beef saw their biggest monthly change in February since November 2003; that was when fears of mad-cow disease abroad led to a spike of export demand for US beef. When the disease was later confirmed in domestic cattle, prices shot down.

So, with food, and specifically meat prices moving higher, the next logical step is that dairy prices are moving higher; up 0.7% from January to February. The price that consumers paid for a gallon of milk was more than $3.56 in February, up more than 10 cents since September. The good news is that the full impact of higher prices hasn’t hit your wallet, yet. For example, the price of a block of cheese on the wholesale market is up 35%, but this price hike hasn’t been passed on to shoppers. The bad news is that those higher wholesale food prices will slowly but surely result in higher retail prices.

Federal forecasters estimate retail food prices will rise as much as 3.5% this year, the biggest annual increase in three years. The reason is simple - drought. We’ve tried to warn you this was coming and it is. California and Texas have seen tight cattle supplies after years of drought. Prices also are higher for fruits, vegetables, sugar and beverages.

In futures markets, hogs are up 42% on disease concerns and cocoa has climbed 12% on rising demand, particularly from emerging markets; coffee prices have soared so far this year more than 70% because of a drought in Brazil.

The price increases pose a challenge for food makers, restaurants, and retailers, which must decide how much of the costs they can pass along. During previous inflationary periods, food makers switched to less-expensive ingredients or reduced package sizes to maintain their profit margins. Retailers and restaurants usually raise prices as a last resort.

In 2008, a spike in food prices caused riots from Haiti to sub-Saharan Africa and South Asia. In 2011, rising food prices were a factor behind the Arab Spring protests in North Africa and the Middle East that ultimately toppled governments in Tunisia and Egypt. We probably are not looking at severe shortages this year, but a lot depends on the weather. If conditions get worse; if the drought gets worse; if the corn and soybean crops in the Midwest get hit by inclement weather; if they do, then we could see significant food price increases.

California farmers say a number of products could be affected later this year, including broccoli, sweet corn and melons from growing regions in Fresno to Huron, where farmers will likely cut acreage due to water shortages. Spring and fall lettuce production in the San Joaquin Valley also could drop by 25% to 30% this year, although growers could try to make up some of that by extending the planting season in the desert and in the Salinas Valley.

Supplies of other items may be supplemented from other growing regions, but at a higher cost. For example, buyers may have to rely more heavily on Florida and Mexico for corn, and there may be more melons coming from Mexico and even offshore. California supplies nearly 90% of the nation's strawberries; growers typically plant a second crop in the summer for fall production; if we don’t see more rain, we won’t see a second planting. It’s not like somebody can step in and fill that void.

For the moment, fair weather accompanying the drought has caused vegetable crops to come to market ahead of schedule, creating an overlap from the deserts and the San Joaquin Valley, creating a temporary oversupply of some veggies. Enjoy it while you can, better yet, can it while you enjoy it.

Stocks are rallying in the wake of the latest developments in the Ukraine region. Gains were broad, with all 10 primary sectors of the Standard & Poor’s 500-stock index higher. Groups tied to the pace of economic growth, including materials, were among the day’s biggest advancers.  After five days of nervous anticipation that held stocks lower last week, stocks so far this week have gone straight up, even with Russian troops massed along the eastern border of Ukraine. In an address to the Russian Parliament, Putin said Russia did not want Ukraine to be divided further, and that he did not want to seize more of the country.

According to Reuters, Crimea may nationalize oil and gas assets within its borders belonging to Ukraine, and sell them off to Russia. The ongoing political standoff in Crimea has already halted Ukraine’s oil and gas ambitions. Ukraine came close to inking a deal with a consortium of international oil companies that would have led to an initial $735 million investment to drill two offshore wells. The consortium led by ExxonMobil, with stakes held by Shell, Romania’s OMV Petrom, and Ukraine’s Nadra Ukrainy, had been particularly interested in a nat gas field in the Black Sea, which holds an estimated 200 to 250 billion cubic meters of natural gas.

If it can get the field up and running, Exxon hopes to eventually produce 5 billion cubic meters per year. Exxon’s consortium outbid Russian oil company Lukoil for the rights to the block. Exxon’s plans for Black Sea nat gas may not have a future if Russia simply takes Ukraine’s assets. The speaker of Crimea’s parliament said that its oilfields should be under the care of Moscow. After Sunday’s referendum, those reserves appear to have shifted to Russian control.

Exxon likely doesn’t see much upside in getting into a tiff with Russia over the Black Sea, especially since it hadn’t even agreed on a production sharing agreement with Kiev yet. But Exxon has billions of dollars of investments in the Russia Arctic in a co-venture with Rosneft, its largest non-US project. If the situation escalates, Rosneft might possibly be targeted with sanctions.

It’s not easy diagnosing the insanity being spouted by the media regarding Russia’s invasion of Crimea, and I don’t claim to have the answers, but it appears to be closely tied to oil interests. It certainly looks like Russia will take Crimea, won’t pay a big price for it, and there’s not a thing anyone can do about it. And the best explanation is oil. Russia is now the world’s #1 oil exporting nation, topping Saudi Arabia by more than a million barrels a day. Russia has an estimated 80 billion barrels in reserves and everybody wants some.

Wall Street has figured out that they can’t allow jingoism to affect their bets. Analysts from Goldman Sachs Group, Bank of America, and Morgan Stanley have said Europe probably won’t back sanctions that limit flows of Russia’s oil and gas. European members of the Paris-based International Energy Agency imported 32% of their raw crude oil, fuels and gas-based chemical feedstocks from Russia in 2012.

Even if Angela Merkel isn’t bluffing when she says Germany is willing to suffer in the cold and dark to punish Russia, she’d have a hard time getting the less disciplined countries of the EU to participate in her stoic resistance. And even if Merkel and the EU can herd cats and present a unified front, Russia will simply sell oil out the back door. Yes, Russia now has a back door. Last year, Russia completed East Siberian-Pacific Ocean pipeline, and that connects Russian oil to China and East Asia.

This weekend on the CNN, Senator John McCain said, “Russia is a gas station masquerading as a country. It’s kleptocracy, it’s corruption, it’s a nation that is really only dependent upon oil and gas for their economy.” Yea, O.K., so what?  You could say the same thing about Saudi Arabia, that beacon of democracy and a fine American ally.

Let’s keep it simple; you probably drove a car today; the food you eat today was transported by truck; everything in this country runs on oil. It certainly isn’t the best source of energy but it is the dominant source of energy. And for a long time now, we have run our foreign policy on the idea of securing oil to keep the economic engine running. We have sent troops into harm’s way to keep the oil flowing. We have sacrificed untold bounty and blood at the altar.

You might think we would be smart enough to step back and reconsider this strategy. It might make sense to concentrate our energy and our brainpower and our capital toward developing alternatives to the insanity.

I can tell you that very soon you will be hearing about groundbreaking alternatives in energy that have the potential to break this old cycle. Energy stories that sound impossible, but just remember, something is only impossible until it is done.