Advice For The Fed

The Fed should raise short-term interest rates soon and by quite a bit. Why, you might ask should they do this? Because rates at zero have done their job and because once the real crisis passed this spring the need for zero interest rates was over. Would it make any difference to anyone in the real economy if short-term rates were 1.5% instead of zero? We doubt it. Would the financial markets scream and yell? Sure. But, the financial markets aren’t the real economy and we shouldn’t let the tail wag the dog. The financial markets would get over modestly higher interest rates a lot quicker than the real economy would, so let’s do it.

The one area where higher rates would be felt pretty strongly would be in banking. One of the big benefits of absurdly low rates is the huge term spread the banks earn by borrowing short to lend long. This would be diminished, but it wouldn’t go away. It would also encourage the banks to lend more of their capital, since with deposit rates below 1% and investment rates more like 4%, the banks are satisfied to sit in investments rather than lend the money into the real economy. If you take away the subsidy for really short money, the banks would be compelled to lend just to protect their margins.

True, the government is also a big beneficiary of ridiculously low rates. With about half of the huge deficits being rolled in the Treasury bill market, the Treasury is able to borrow at almost nothing to support the massive deficits we are generating. Higher bill rates would cost us all quite a bit but it might be worth it if we could get rid of all the disincentives that zero interest rates create.

Higher rates sooner would mean that the whole process of raising rates back to a more normal level would begin. That beginning would be an important signal to the economy, the markets and the government that the crisis is over and that normalcy is slowly returning. More normal markets don’t need zero interest rates. We would also not be faced with the prospect of a long, drawn-out series of dinky little interest rate increases starting some time next year and going on and on for a couple of years before the yield curve started normalizing (from being ultra steep now). If the Fed followed the Greenspan example of raising rates slowly, 25 basis points at a time, it takes four Fed meetings, about half a year, to raise rates one percent. We need a lot of these to get more normal. At 200 basis points a year, we are about 18 months away from normal now.

A one-shot rise of 150 basis points would send a shock to the financial system. That might be reckoned to be like a defibrillator or maybe a taser shot (remember “don’t tase me bro”?). Either way, the economy might be better for it. We’d guess that the financial markets wouldn’t like it on the day it happened. But, a couple of weeks or months later, we’d be better off for it, too.

The Fed isn’t likely to raise rates soon. The last time they listened to your pundit (well let’s see, that hasn’t happened in a long, long time) things worked out well. Your pundit was a big fan of the inscrutable Fed of yesteryear. The whole ‘transparent’ Fed of the Greenspan years and beyond isn’t quite as good for business. When the Fed listens to the market more than the market listens to the Fed, there is something fishy going on.

If you want to know when the Fed will finally raise interest rates, just watch the Fed Funds futures or the Treasury bills and when they both trade north of 25 basis points for a while, the Fed will raise the Fed Funds target to a minimum of 25 basis points. The Fed will generally follow the market these days rather than lead it. What good is a Fed who won’t lead? It doesn’t make sense. The Fed has to rule by intimidation and surprise. The Fed shouldn’t be transparent. It should be inscrutable.

A big piece of this last bubble in debt can be laid at the Fed’s feet. The apparent transparency and the friendliness of the Fed reinforced this illusion of a low-risk investing environment. All investing is risky. People who do it should recognize that. Promulgating a low-risk environment is just asking for trouble. The Fed can’t be the market’s friend one minute and then be its policeman the next. Pick one! (The right answer is policeman.)

Good Economic News

Leading indicators for July rose by 0.6% after a revised gain of 0.8% in June. This is one of the better indicators that the economy may soon begin to rise again. Consumer confidence, one of the 10 leading indicators, declined in yet another example of the consumer’s reluctance to join the economic recovery.

The International Monetary Fund thinks the global recession is over. Their chief economist argues that we will see growth, but modest and perhaps erratic growth. The economy has been ‘scared’ by the recent collapse and recovery will be slow. “The turn-around will not be simple” according to the IMF.

Existing home sales rose for the fourth straight month. Sales of foreclosed or distressed properties helped(?) in getting the number up as these were nearly a third of total sales. The monthly total, 5.24 million homes (annual rate), was a gain of over 7% from June. The modest rebound in sales is likely driven by low mortgage rates and incentives for first time buyers. We are still not seeing any animal spirits among real estate speculators. That alone may be a good reason to think about buying in some markets where the fundamentals are better than the national averages (not in specific markets where the real estate collapse continues).

Other Economic Numbers

Producer prices fell for the month of July. The drop of -0.9% was about as expected by economists but still somewhat unnerving. Food and energy prices fell during the month, though that doesn’t jibe with what we feel when we buy groceries or gasoline. Maybe that is just because we tend to be a little cheap. Core PPI also fell, but only by -0.1%.

Housing starts didn’t follow the June spurt but fell back to 581,000 from the 587,000 the month before. This was less than the economics community thought would be reported. But, this is such a volatile number with all sorts of small issues causing rather big changes on a month to month basis, which we as investors get way too focused on these monthly numbers. The trend is more or less flat over the last several months at roundly half a million homes started. That is all we really can take from this number.

Weekly Stuff

Chinese stocks were in the headlines a couple of times last week. The Shanghai and Shenzhen market indexes were both very volatile. Chinese stocks lost almost 6% on Monday, gained some of that back on Tuesday and then fell again on Wednesday by 4%. The cumulative drop in Shanghai is now more than 20% since the high there on August 4th. Since last November, Shanghai stocks have rallied from about 1700 on their index to about 3500, so roundly a double. Now, they’ve slipped from 3500 to below 2800, a drop of 20%. Should this be unexpected? Oh no! In a volatile market like China, with the huge ebbs and flows of capital that slosh around in that market, it should be expected that we’ll get outsized wiggles along the way. This is a market that fell from over 6000 a year-and-a-half ago, so anything is possible.

What is more interesting is that the rest of the world followed China’s wiggles with such close reactions. Last Monday, almost every market around the world was down in sympathy with China. On Wednesday, it wasn’t quite so universal. What is truly marvelous for those of us who think the new bull market has started and worries about an imminent collapse back to old lows are misplaced is we took this blow and still had a positive return for the week. On Monday, our market collapsed at the open, but it cut its losses in late afternoon trading. We rallied on Tuesday with the rest of the world. On Wednesday, we collapsed all over again, but then we turned it around and ended the day up. Thursday and Friday were gainers and we actually hit new recovery highs on Friday.

What makes all this so fantastic is that it is happening during a period where we ought to be slipping and consolidating our prior advance. Maybe the lull in July and this wiggle in August are all the consolidation we need. Maybe the smart money buying in the late session most days since March are right. But, with the A-team on vacation on Wall Street, the second string is putting up good numbers. It looks like a romp for the bulls.

Besides the US, many European markets gained last week. There was weakness in the developed Asian markets, but with your largest supplier and maybe largest customer going through gyrations, that makes some sense. Latin America was largely higher and the emerging markets overall gained modestly despite China being down.

This is August, the dog days of summer, and it is also a fairly boring period for the market fundamentally. The earnings reports from June 30 are largely over and they were better than expected overall. We still have to wait another six weeks before the next batch of earnings starts again. We have a huge share of the entire market on vacation and still the market is able to absorb the kind of action we had last week. Your pundit is impressed.

Bonds did less well last week. In a mirror-image of the stock wiggles, bonds were generally up on down days for stocks and down on the up days. So, the bonds ended up trading down. That covered almost the entire bond universe. Our high grade manager managed to show a modest gain, but Treasury, agency and mortgage bonds tended to be lower on the week. High yield corporates were about unchanged and high grade corporates showed small gains. Much sound and fury, signifying nothing.

Foreign bonds had the benefit of a lower dollar and generally favorable economic news (that is bad news, which for bond buyers is good news).

Real estate markets were generally higher again. The hue and cry from the banks and Congress (the opposite of progress) that something has to be done to help the commercial real estate industry probably signifies that their troubles are about over. We could probably use a clean-out in retail and maybe a little more apartment building, but overall there aren’t that many sectors in need of huge changes.

Broad commodity indexes were pulled higher by the energy sector, again. What we saw was a big move in crude oil that was not followed by many other sectors of the commodity world. Some precious metals eked-out gains but many other areas were down. The magic of oil is that demand is largely unaffected by economic activity. So much of our energy use is for heating, for electricity generation and for transportation that there isn’t a lot of demand that gets shut-off when the economy flags. The delivery route still has to be made even if orders are lower than usual and several stops are no longer in business. The savings are not material from some of us not taking a vacation.

Au revoir 

Have a really great week.

Karl Schroeder, RFC

Investment Advisor Representative

Schroeder Financial Services, Inc.