Issue of the Week
Though not precisely an issue for this week so much as for the next several weeks to come, the imminent culmination of the Fed’s QE2 has more than a few people concerned. Just to set the stage, if QE2 was so crucial to the survival of the human species last October when it was proposed, why is it not so after June 30? Do we not want to leap right into a QE3 if for no other reason than to postpone the end of civilization as we know it? Are we to believe that with the Fed’s retirement from actively supporting Treasury bond prices by being a committed buyer at almost any price will Treasury bond prices now come off the rails? These are not trivial questions, or so they seem. (Okay, that’s a little sarcastic for everyday comment, but it is really hard to take the subject all that seriously. Western Civilization as we know it was never going to cease, just because of a little economic misstep.)
First let’s review what QE or quantitative easing is all about. What the Fed does is use a quantity of money (that’s the Q part) to impact the stock of money outstanding and at the same time the cost of that money, interest rates. Back in the good old days, this was called Open Market Operations and could go either way, adding to the stock of money or reducing it. QE goes only one way, more money. So, QE2 will have added about $600 billion in cash to the balance sheets of America’s banks by buying that much in Treasury debt, creating the purchasing power from thin air. The Fed can do this not because they own the printing press (the Bureau of Engraving and Printing in the Treasury Department owns that) but because they can expand their own balance sheet at will.
So, QE started as a response to a slackening pace of US growth in the middle of last year, when the surge of growth ostensibly generated by QE1 had reached its zenith and begun to decelerate. So, QE2 was supposed to get us to a point where the natural animal spirits of the marketplace were to take over and propel the economy forward under its own momentum. Are we there yet?
We have been critical of the Fed’s easy money policy for a long time. They have not heeded our advice to claim victory over the forces of darkness and declare an end to the crisis response started immediately after the collapse of Lehman Brothers in the fall of 2008. Zero percent interest rates might have made sense for a little while immediately after Lehman when the entirety of the banking system and Wall Street were suspect. But, by force-feeding the big banks the TARP funds and the Fed buying about a trillion dollars in questionable mortgages to clean up the balance sheets of the suspects, we got past that point. Since then, the big banks have returned to something akin to normalcy, earning a huge amount of money due largely to the Fed’s zero interest rate policy and related steep yield curve. So, if the banks are more normal, why are we still operating in crisis mode? Inquiring minds want to know.
Could it be that without some sort of outside stimulus our economy can’t make any headway on its own? If that’s the case, we’re going to be in trouble for a long time. QE2 will be followed by QE3 and then QE4 and so forth ad infinitum. If we follow that example, we will be a banana republic before we know it. There has to be an end to this artificial state of affairs sooner or later. For about the fifth time in about as many weeks, we will paraphrase Herb Stein (former Nixon economic counselor and father to actor, writer, economist Ben Stein) “if something can’t go on forever, then it won’t.” If we inflate the money supply without limit, the money will rapidly become worthless. Since having worthless money is worse than having money with some modicum of value, we will stop inflating money before it becomes worthless. Our tiff with the Fed is about when to stop devaluing money, not about if we will stop. We think the time is long past.
Getting back on topic for a moment, the concern of many, including PIMCO bond czar Bill Gross, is that when the Fed stops buying Treasury bonds, then the interest rate on those bonds will begin to rise in earnest. That may be how it works out. Not all bond guys agree with Gross. But, we think the odds favor some sort of negative impact. Let’s do a little math to see if we can get some clarity on how. The Fed is buying about $100 billion in Treasuries a month in QE2. The Fed is also buying about $50 billion to $75 billion just to keep their balance sheet from shrinking (as that trillion dollars worth of junk mortgages gets refinanced, or pays interest and principle, the Fed has to spend that money). So, this month, they will buy between $150 and $175 billion of bonds. In July, once QE2 is over, they will evidently slow their pace to a mere $50 billion to $75 billion. We are arguing about $100 billion, not like real money, right? So, in a market with some $8 trillion of marketable securities, nearly half of which are bills, buying or not buying $100 billion in a given month may have some impact.
When the Fed itself was contemplating QE2, their rocket scientists guessed that buying $75 billion to $100 billion regularly would bring down interest rates by 40 to 50 basis points. So, does it stand to reason that not buying $75 to $100 billion may cause rates to rise by that much? We’re about to find out. But, more importantly, that is likely the scale of negative reaction we expect to see when QE2 ends. That won’t be a lot of fun for the folks who own Treasury bonds, but it won’t likely result in any slowdown in the economy or fix any of our other problems. Western civilization as we know it will survive one more time.
The FOMC Announcement (see above for historical relevance) was a non event in many ways as the Fed opted to leave their ultra-easy policy in place. However, the Fed did break new ground by having the Chairman, Dr. Bernanke, hold a press conference shortly after the meeting broke up. This sort of transparency is used by other central banks but we think the whole movement toward transparency by the banks misses the point. There was a certain degree of power in the former mystery surrounding the Fed. If Wall Street knows just what the Fed is doing then they can bet on it. They will tend to make huge bets on it. If Wall Street doesn’t know what is really going on behind the curtain (see “The Wizard of Oz” for clarification of that one) then Wall Street can’t make absurdly large bets either way. Life was better when the Fed was more opaque.
US GDP in the first quarter grew. It didn’t grow as fast as most forecasters had guessed early in the year, but a combination of lots of winter storms on the Eastern Seaboard, high gas prices, widening trade deficit and slowing investment in inventories held back the gains. The initial estimate of 1.8% growth in the first quarter was actually better than many of the guesses just prior to release of the data, but well below what was typical just a couple of months ago. It was fashionable to believe that the US economy had turned a corner after the fourth quarter release showed a stronger consumer, improving exports, lots of investment and inventory building.
This is the first of three estimates of the first quarter growth rate. A month from now, we will get the first revision of this guess with a lot more data available on February and March. Then in June we will get the final (which is far from final) revision with a lot more data on March. This guess has a lot of data on January and some on February, but as more data is available, the number will shift. We are frequently amazed at how accurate the Wall Street economics fraternity is with their guesses while how often erroneous the government’s own forecasters can be. We suspect that most revisions will be higher in coming months since that was where most of the Wall Street estimates were earlier.
Personal Income rose 0.5% in March according to the Commerce Department. The gain was much stronger than expected and reflects several seasonal impacts from annual bonus payments to accelerating new hires to modest hourly pay increases.
Consumer Spending rose in March at a faster pace than expected. We seem to be rebounding from the weather and news induced slowdown in January and February. The 0.6% pace would indicate that GDP may be accelerating.
Since spending rose faster than incomes, the personal savings rate fell to 5.5% in March from 5.9% in February.
New Home Sales rose in March from a depressed February. The Commerce Department announced an 11.1% rise in sales of new homes to 300,000 units. The number was better than expected and shows that there might be some glimmer of hope in housing. Just a glimmer, don’t get your hopes up too much, too soon.
The S&P Case-Shiller Home Price Index fell again in February. The decline of 1.1% was bigger than expected and broader as only one of the 20 cities covered in the index saw prices gain. We are within a short distance from the April 2009 low for house prices and likely to reach that level if current trends in prices persist.
Consumer Confidence rose in April from the disaster-prone March reading. After the earthquake and tsunami, the near meltdown and release of radiation in Japan, April must have seemed almost idyllic. But, the actual number only went up to 65.4 from 63.8. We have a long way to go to get Consumer Confidence back to the 1960s level of 100.
Just when a lot of commentators were starting to think they were on to something with all the scare talk about the market facing some stiff technical resistance, an unfolding Arab Spring that held the media in its thrall, a slowing economy as depicted by the 1Q11 GDP results, and slowing (though still growing) earnings growth. The clamor was all about limits to the bull market. But, guess what? We ignored is all and went to new recovery highs in most of the indexes and new all-time highs in the small caps. The brouhaha about the end of QE2 (see above) was supposed to kill bonds, but bonds had gains as well.
This benign environment wasn’t limited to the US, Europe had a pretty good week as well. Asia wasn’t quite so sanguine. Most of Asia, ex-Japan, fell last week. The news on Chinese efforts to restrain inflation in the middle Kingdom cast a pall on the continent. Oh well, you can’t win them all.
Bonds did well almost everywhere with foreign markets getting quite a boost from the weak dollar. The buck fell over 1% last week alone and has fallen 7% year-to-date. As we have said innumerable times before, it is the unspoken policy of this administration, like many administrations before it, to reduce the value of the dollar. The goal is to stimulate trade, the effect is to import inflation. Most US exports to not compete on price. Boeing jets, Caterpillar tractors, Intel chipsets, movies, legal services, financial services, etc. to not have to compete on price. At the other end of the spectrum, wheat, coal and logs also do not compete on price. All that happens is that the price of our oil addiction goes way up. It is just funny how the policy establishment is still reading their Econ 101 books for the answer to this problem when all they have to do is look at history. The weaker the dollar gets the bigger our trade deficit gets.
Dr. Copper says no. The question was “are commodities going to go up forever?” This isn’t Jeopardy, where they give you the answer and you have to come up with the question. We had the answer from copper and we had the question from the media. We just put the two together. The huge run in commodity prices is already getting a response in the market as companies shift demand from one commodity to another to avoid higher prices. As we have repeated ad nauseum, the cure to high prices is high prices. Demand destruction follows and lower prices follow that. The commodity bull market will continue, but not in a straight line and not every day. Copper prices have already seen a bit of a drop-off due to slower demand. The price of copper has gone from $0.50 a pound to $4.00 a pound. Not everyone who wants to use copper and afford it and demand has dropped-off. The same is true of just about every other commodity. A double in cotton prices last year lead to more acreage planted in cotton this year. Record corn prices means farmers will plant fencepost to fencepost. High oil prices mean we turn down the thermostat and drive a little bit less. These are self-correcting mechanisms, but it can take time.
Real estate prices seem to be firming in commercial markets. They had better, given the movement in the real estate related securities. Without a pretty darned good rally in the price of commercial real estate, the REITs are stretched as it is. Improving fundamentals will take time but the REITs aren’t waiting around.
Have a great week.
Investment Advisor Representative
Schroeder Financial Services, Inc.