Is the Fed's Growing Balance Sheet a 'Free Lunch'?

One of the hallmarks of the "Great Recession" has been the Fed's easy money policy, which has manifested

itself in low interest rates (ZIRP) and, the now famous, QE (Quantitative Easing or money printing).

As we entered the Great Recession in 2008, the Fed seemingly had few options to assist the economy and stave off what could have been a more severe depression. In an effort to stoke growth in the economy, the Fed cut interest rates to near zero and ultimately implemented QE, that expanded the money supply and has since led to the rise in value of risk assets, like equities, among others (at the time of this article most US stock indices sit at record levels). The concept behind raising the value of assets, like equities, was to create a "wealth effect" that would start a virtuous cycle of more consumer spending and more capital investment. As a result of the Fed's policy, its balance sheet has expanded at an unprecedented pace.

Are there ramifications to the Fed's growing balance sheet? Is the Fed inflating another bubble like we saw in 2000 and 2007? Or, is there such a thing as a 'free lunch'?

Growing Balance Sheets

As seen in the image above, the Fed's balance sheet grew steadily from 2001 until 2008, showing a balance just shy of $900 billion. Then, over night, its balance sheet experienced a dramatic increase

only to be followed by an endless run of quantitative easing. However, the US Fed is not alone in its endeavor to kick start the economy through asset purchases. The second image reflects a global policy of asset purchases resulting in increasing balance sheets. What impacts might be felt as a result of this global policy, specifically, to the U.S.? Is there comfort in the knowledge that the U.S. is not alone in its policy of QE? Or is there concern that we are now the leader in this effort? The U.S. Fed's balance sheet shows the most dramatic change of all of those represented in the attached image.

Another Bubble Inflating?

Through its efforts, is the Fed simply creating another bubble from which we will suffer yet another dramatic decline and an additional assault on the fragile psyche of most investors? "This time is different" is a popular, and to many investor's ears, chilling refrain, often used to explain away concerns regarding the latest dramatic rise in some asset class's value. So, can the Fed orchestrate a slowly recovering economy and rising asset prices without a costly glitch? The short answer is "maybe". If the economy progresses to a more healthy level of growth and the fundamentals better match the performance of stock indices, record stock levels could be sustainable. However, another recession, and or, runaway inflation could knock markets from their highs. The unanticipated contraction in first quarter GDP and the rise in inflation has some analysts and money managers on yellow alert. They're not quite at red alert, yet. The popular and tiresome weather excuse has provided cover for bulls so far, but that excuse is losing some luster as data collected for the winter months is replaced by spring and summer data. If these concerns manifest themselves and markets take a hit, what implications does this have for a Fed with an inflated balance sheet?

Foreign Creditor Confidence?

With the Fed claiming that it can and will hold the securities it purchases until maturity, it only signifies that the market will not have to absorb the supply at some point in the future, but that does not relieve the Fed from the effects of rising interest rates. The cost of holding securities in the face of rising interest rates is material and significant. The impact of inflation on the value of the U.S. dollar and on interest rates is a two-pronged financial sucker punch. Because commodities are priced in U.S. dollars, a falling dollar means higher costs for U.S. corporations. Rising interest rates make the debt the Fed is holding less valuable as an asset and rolling over the debt becomes more expensive. One implication is that foreign governments might be less inclined to hold U.S. debt in the face of a falling dollar. Until now, the Fed gets the benefit of the doubt from its creditors. If foreign investors were to lose confidence in U.S. fiscal and monetary policies, an already bloated Fed balance sheet would be challenged to absorb more debt from the secondary market. As the balance sheets of other nations grow, combined with falling dollar-denominated assets, foreign governments will be less inclined to add more U.S. debt on to their balance sheets, choking off an avenue of funding for the Fed. Additionally, if a large holder of U.S. debt were to liquidate suddenly, this would serve to drive up interest rates and drive down the value of the U.S. debt.

Market's Love-Hate Relationship with Inflation

On the one hand, markets rely on some level of inflation. Without inflation, capitalistic economies do not function properly. Some level of inflation allows the successful use of debt financing. Inflation, in this case, represents growth. It allows the prices of products that companies sell to go up and it degrades the value of debt used to finance that production. At a minimum, it keeps the price of products from falling below the cost of production. As the cost of debt is fixed, inflation provides margin for profit. However, inflation also reduces the value of cash flows, which in turn reduces the value of the underlying company or asset. Too much inflation will creep in to income statements in the form of higher production costs at the same time as reducing the value of dollar-denominated assets. The Fed's large balance sheet could be the cause of a spike in inflation for the reasons noted above, and if that inflation were to get out of control, markets would react negatively and a large sell-off in both the equity and fixed income markets could follow.

Summary: Is There a Free Lunch?

So far, it's hard to say that investors have not enjoyed something akin to a 'free lunch' as the Fed has successfully orchestrated lower costs of capital and rising asset prices. What's unknown, however, is how long the current environment of low volatility and rising asset prices can last. The current bull market is five years old and counting. As values get extended and the market does not experience a traditional correction, the prospects of a more severe correction grow. In the absence of some catalyst that would alter current trend, this condition can last for years. However, the degree of Fed intervention and market manipulation has most professionals uneasy. This unease from the street can have its own effects. Unfortunately, most folks on Wall Street, do not subscribe to the notion of a 'free lunch' and are skeptical that current conditions controlled by the Fed, and its money printing (QE), will go on ad infinitum. In the absence of higher growth and a healthier consumer, that very fact could be the spark that causes the flame.

The European Central Bank Eases. Will it Help?

In an effort to stimulate a lethargic economy and stave off impending deflation, on Thursday, June
5th, the European Central Bank(ECB) cut its main rate from 0.25% to 0.15%, cut its marginal lending facility from 0.75% to 0.40%, offered its longer-term refinancing operations (LTRO) and imposed a negative interest rate on bank deposits(from 0.0% to negative 0.10% - the first ever by a major global central bank). In an odd and unexpected twist, the Euro actually rose after the move. The rising Euro, if it were to continue, would act to defeat the efforts by the ECB. Despite the moves made by the ECB, and the resulting impacts on currencies and markets, will they have the desired benefit of stimulating the European economy?

The Deflation Threat

The ECB has targeted 2.0% as its desired inflation rate. Last month inflation was running at around 0.5% in the Eurozone. One of the biggest fears of advanced economies is the specter of deflation, which we have covered extensively on this blog because of its debilitating nature to an economy. In a nutshell, deflation dampens economic activity for various reasons, not the least of which, is causing the consumer to put off purchases in the face of falling prices. If the ECB is to be successful in stimulating economic growth, it must first combat deflation.

Austerity to Blame?

To combat the global recession, the European Union adopted austerity measures in hopes that it would allow them to reduce the amount of debt overhanging its members. While certain levels of austerity are helpful when recovering from economic recession, an overwhelming amount can harm growth and limit the speed of a recovery. The most efficient response to the economic weakness was not to curtail borrowing as much as it was to provide the environment for healthy borrowing through lower rates and solid credit policies. Cutting back credit would only serve to limit growth potential and spur further deflation.

Draghi to the Rescue? The New Bernanke?

With austerity measures fully in the rearview mirror, the ECB's head, Mario Draghi, has unleashed the aforementioned measures in one fell swoop, but came just short of implementing US style asset purchases. The assumption here is that they're coming, and Mr. Draghi is simply biding his time. If the recently implemented measures fail to accomplish the desired results, a healthy round of asset purchases will inject liquidity in to the economy creating the necessary 'wealth effect' and in effect buying yet more time for things to improve. With the US as a proxy, the Eurozone can use this blueprint and better anticipate the results. Rising equity markets is one expected outcome. Will this be enough to stimulate economic growth and lead to a hiring boom, something the US claims to be experiencing? It's difficult to tell, as Americans and Europeans are alike, and they're not. The employment rate in Europe is significantly higher than the US, indicating a more severe structural problem, maybe not easily solved through liquidity.

Effects on US Markets

One of the conundrums facing the US market was falling interest rates, leading some economists and analysts to worry that a recession was in the offing. However, more likely, it was a result of the impending Eurozone stimulative measures. In addition to falling US rates, equity markets have responded favorably to the moves, with US equity indices at record and historical levels. Most global equity indices are following suit with European markets are equally reaching record levels. Are these record equity levels a boon that should be enjoyed or are they indicative of the effects of rampant global liquidity injection and should investors be wary? Only time will tell, but an old cliche can provide some perspective: "There are no free lunches..." In other words, if rising equity markets seem too good to be true, they probably are.

Are Bond Yields Trying to Tell Investors Something?

The latest concern on the tips of investors tongues is: what, if anything, are falling bond yields trying

to tell the market? The concern is legitimate, as falling interest rates typically precede a recession, and with the major stock indexes flirting with historic highs, a correction could be in the offing. Are investor's concerns justified? Depending on who you listen to, investors may or may not need to worry.

Why Are Yields Falling?

The only reason falling rates is raising a red flag, in the first place, is that it does not jibe with a recovering and growing economy. Falling yields, or rates, are typically associated with a poor economic outlook. As an economy strengthens, and its outlook improves, long term interest rates typically rise as inflation becomes a concern. The fear of inflation is associated with falling bond prices as yields rise. Investors anticipate Fed intervention to cool a overheating economy which leads to rising yields. It's a self-fulfilling prophecy: investors expect the Fed to raise rates so they beat them to the punch and start to sell bonds. The logic and disposition of investors when the opposite is true is that something must be wrong with the economy when yields are doing the opposite. It is a justifiable concern. The reality is that although money manager insist that the economy is on the mend, the data doesn't support this position.

Economic Data

After heating up, real estate seems to be faltering, despite higher than anticipated housing starts on Friday. Most other metrics are not as robust. Another housing market concern: weakening demand. Fewer young folks are seeking homeownership, nor can they afford it. In addition to real estate, the consumer is another concern. The anticipated rebound on retail sales has not materialized as some had predicted. One suspect to look at for a weak consumer is prices at the pump. There is no way around $4 a gallon at the pump. Consumers have to fill their tanks to get to work and that eats in to discretionary income, and therefore less spending on other items.

The Fed

Economic data aside, the Fed is still in play regarding asset purchases. It may be purchasing less but it is still buying upwards of $40 billion in bonds each month. That's a lot of assets. So, there is still downward pressure on yields, from the Fed alone. The fall in yields has been associated with a bump in mortgage refinance applications as reported by the MBA. This is a desired result of the Fed as it eases stress on the consumer.

Is Something Else at Play in The Market?

The famously ebullient Jim Cramer, of CNBC's Mad Money fame, offers another option as to why yields are rising: an investor mentality paradigm shift. The host of Mad Money may be on to something. After two significant market declines, investor's timidity is understandable. The retail investor just has not embraced this bull market, in fact, has resisted this market recovery, viewing the disconnect between Wall Street and Main Street as their main concern. Are investors favoring the security of US treasuries over equities more now than in the past? An argument could be made that, in fact, they are, despite historically low yields. The mentality being: a little gain is better than a big loss. An interesting observation this year versus last year: all the talk of a "Great Rotation" last year is completely absent from todays news stream and headlines. Is there even such a thing as a rotation to even consider it as a possibility? Some analysts say it was never an option. What is interesting this year, however, is that no one is suggesting one. This could mean different things, but it, at the least, suggests investors are not anticipating large sales of fixed income securities.

What Does it All Mean?

The real concern might be the divergence that is occurring in the equity markets in addition to falling bond yields. High tech, high momentum, small cap stocks are skidding while investors are seeking the safety of large caps, thus we see historical highs in the Dow and S&P 500. Also, when large players, like David Tepper, start suggesting caution, it warrants attention. Is it time to take some money off the table? Maybe "sell in May and walk away" is justified this year.

Large Housing Investors: An Unforeseen Consequence

One of the largest catalysts of the Great Recession was a collapsing housing market. To be sure, prices had gone too high and some air had to be let out of the balloon. The subsequent collapse of CDO securities exacerbated the financial collapse that nearly sank the global economy. Once the long process of healing finally set in, one area that most analysts and economists anticipated would lead the recovery was the housing market. The only problem was that housing didn't get the memo. What went wrong? Why were so many folks off the mark regarding housing's eventual lethargic recovery and near stall? Enter the large institutional investors.

Large Institutional Investors Fill the Void

To take advantage of a market opportunity, which is what large institutional investors do, they came in with cannons loaded to the tune of billions of dollars. They bought wholesale large swaths of single family residences in the worst hit markets hoping for a bounce back. With access to cheap money and cheap inventory, the buying bonanza began. This phenomena helped the housing market stage an initial recovery. Prices started rising and with so many former owners looking to rent, properties could be rented for income purposes. But renting was never a long term goal for the large investors, as property management wasn't their business or goal. The inevitable buying ended once the cheap money ran out and the inventory eventually ran out. A big reason the inventory dried up was because all the while homebuilders had been sitting on the sidelines and to this day have not resumed past building patterns.

Squeezing Out the Few Little Guys

In economics there is a phenomena known as 'squeezing out'. This is when one form of capital displaces another form of capital. In the case of housing, the large investor has squeezed out the smaller more organic buyer. Large investors targeted the niche market that would normally have been available for the first time homebuyer. After driving up the value of this market, sopping up the inventory, in conjunction with rising interest rates, large investors contributed to a perfect storm that has all but eliminated a large part of the demand side of the market. This, combined with a still weak and slowly recovering economy, has resulted in a more anemic recovery in housing, confounding most analysts and economists.

Ukraine: Is A Russian Conflict Discounted In To Global Stock and Bond Markets?

Is A Russian-Ukraine Conflict Discounted In To Markets?

After a brief flight from risk and run for cover, equity markets and bond markets are adjusting to the idea of conflict on the Crimean peninsula. But are these markets accurately accounting for the rise of a real conflict between Russia and its former territory? Given the growing hostilities between the two nations, and US equity indices heading back toward record levels, it is hard to accept that a real conflict is priced in to markets.

As of this writing, Russia is amassing troops and running exercises near Crimea and the Ukraine has "eliminated" some "terrorists" that had set up road blocks. These are, so far, relatively minor incidents. However, wars have been started for less, especially, if one party is motivated by hostilities. Through referendum, Crimea has voted for its secession from Ukraine, which Russia acknowledges but the European Union and the United States do not. The US accuses Russia of inciting unrest in the region which Russia strongly denied. Over half of the Crimean population is of Russian ethnicity, accounting for why a referendum would be successful. So why the hostilities, why now? Russia, and Putin, its leader, could well be motivated by both economic and military interests. The ports in Crimea represent access points that represent maritime routes to the Mediterranean and to key Russian military bases in Crimea. As Ukraine distances itself from Russia, Russia may fear losing access to these strategic routes and its military bases. The area also has significant energy reserves in the form of gas. Is this incentive enough to start a potential military conflict with a heavily nuclear-armed opponent? It could be if Putin's ego is large enough, and the recent winter Olympics reflect at least that much.

Why Do Markets Care?

Markets dislike uncertainty. It could be its most detestable concern. Markets can handle most any issue that arises and discount it in, or price it in, accordingly. What markets struggle with mightily, is the unknown. How do you price in something you cannot evaluate or measure? That's what markets struggle with the most and why political and military hostilities pose such a threat to markets, both equity and fixed income. Typically, uncertainty is reflected in markets by a flight to quality, which is reflected in a sale of risk assets and the purchase of US treasuries, seen as a safe haven. The implications are immense. The importance to money managers is return performance, and to consumers is interest rates. A flight to quality can lower mortgage rates which benefit homeowners and homebuyers.

Is the Possibility of a Conflict Priced In to Markets?

The point of the article is to explore whether or not the possibility of conflict is accurately reflected in both equity and fixed income markets. Given elevated equity levels near all time highs and relatively high interest rates, as of now, it seems markets are not truly reflecting a real conflict is on the horizon. Where should equities and interest rates be? It's hard to say what would reflect a proper accounting for this possibility but some risk premium should be evident in both markets to account for possible hostilities. Equity indices should reflect some spread below where they could be absent any conflict whatsoever, and fixed income assets should show some spread above where they should be. The inherent problem with this logic is that, since the economic recession and extreme Federal intervention to stabilize markets, it's difficult to ascertain whether markets again expect Federal intervention in markets if a real conflict emerges and therefore is not discounted in properly.

Conclusion: The Fed Saves the Day...Again.

After a nearly unstoppable five year run, the bull market continues its stampede with the Fed tailwind behind it, and no conflict is insurmountable from the markets perspective. The possible Russian-Ukraine conflict will prove this again. Investors will cavalierly place their bets that any hiccup caused by geopolitics will be swept away by more liquidity and more artificial stimulus. This observation is not cynical but based on the past five year history of how markets are behaving in the current environment. What is unknown, and the market should despise is, what will be the cumulative effect of looking past all of these market hurdles, that the Fed has offered a soft landing, when it steps back?

Corporate Earnings Are Coming: Is Weather A Built-In Excuse?

George R.R. Martin has given life to the phrase "Winter is coming" in his expansive fantasy series

Game of Thrones. However, this phrase seems to have caught on with corporate America as it is being used as a scapegoat for weaker than expected earnings

Alcoa kicked off earnings season after the market close yesterday, the first of many earnings to come out over what seems like an endless parade, blurring the end of one earnings season and the beginning of another. After what has been a stellar period of earnings, corporations are challenged to maintain robust earnings growth. One challenge has been difficult comparisons. Earlier earnings easily hurdled prior weak earnings. But as earnings rose and after implementing financial engineering (read: stock repurchases via low cost borrowing) to continue the strong results, corporations are running out of growth and strategic options to paint a strong picture, all in an effort to justify and add to historic equity levels. Enter the excuse parade, and what better after a difficult winter than to trot out the weather excuse? Is weather a reasonable excuse for poor earnings? If the weather were mild would sales have been more robust? Did this winter more adversely affect U.S. businesses than past winters? Is there a typical winter effect?

The Growth Challenge: Revenue, the Bottom Line

The stock market gets its juice from discounting higher future earnings growth. Without it, earnings are simply an annuity with a value attached to them, the only variable changing is some chosen discount factor. Otherwise, the math is pretty straight forward. For the value of a company to go up, and therefore its stock to rise, earnings forecasts must constantly rise. This is the challenge corporate America faces today. Revenue growth is stagnant, so, corporations elected to reduce the number of outstanding shares to reduce the denominator in the earnings/share ratio to make earnings look better. Once corporations run out of either stock to buy back or cheap money to do it with (what we will be seeing more of as interest rates rise) earnings growth will have to come from somewhere else. This is where we will see if the economy is healing or if the stock market has gotten ahead of itself. To sustain a rising equity market, investors will look to earnings and forecasts to make investment decisions on whether to remain bullish or become more cautious.

Enter the Blame Game

The most convenient excuse for earnings disappointments is bad weather. The problem with this excuse is that when earnings surprise to the upside weather is never trumpeted by CEOs as the reason. At least if this were the case sometimes, investors could buy the excuse for poor earnings. When corporate earnings for companies located in moderate weather climates disappoint it also flies in the face of using the weather excuse. What weather excuse do Californian or Arizonan companies use? Rain? There is currently a drought in California. Floods? There are floods in Arizona every year. This winter the east coast has suffered through a severe winter, to be sure, and weather will be used as a legitimate excuse in some cases. But as winter becomes a distant memory and we move further in to spring those excuses will ring hollow. And what of bad weather every winter? Retail sales dip each year when the weather turns cold and stormy. Is each year identical from a weather stand point? No, they are not. Therefore, companies will continue to use the blame game as it is impossible to compare one year to the next. It would prove extremely difficult to accurately show how much weather affects results from year to year. No baseline exists to look at.

Conclusion: Investor Tolerance

Ultimately, it is up to investors, that put up their hard earned dollars, to decide whether disappointing earnings are an anomaly and are not a cause for concern of a larger problem. Investors will look around and decide if an entire industry has been affected by some common factor and allocate their dollars accordingly. If investors find that certain corporations have been disingenuous about the reason behind disappointing earnings, they will penalize those corporations with their investment decisions.

Good Morning, We Are Japan

For years there has been a vehement denial by U.S. citizens that we as a nation and culture are not

Japan. This argument generally comes up whenever the U.S. economy struggles and growth slows, not unlike the current environment. Often times, when the U.S. economy slows, the response by the Fed is to stimulate through open market operations, which is just another reference to quantitative easing, with the intended consequence of lower interest rates. The inevitable comparison is with Japan's uneven success with a zero-interest rate policy (ZIRP) for the past two-plus decades. Will we ultimately find success with our version of ZIRP? Are we destined to commit the same mistakes as Japan and follow in their footsteps? The denials are understandable but misplaced as we just might be more like Japan than we would like to admit. Additionally, let's explore whether it will ultimately affect our fate or even matter.

The Inevitable Comparisons

For years Japan was the second largest economy before being surpassed recently by the growing economic powerhouse that is China. Japan's economic model was based on being a large net exporter of goods. As a result of WWII, the US's fear of the spread of communism in Asia and corresponding economic assistance, and Japanese economic protectionism and extreme government intervention, Japan's economy flourished post-World War II through the 1980's (known as the 'Economic Miracle'). As a result of loose monetary policy throughout, asset bubbles were created including but not limited to Japan's land values and stock market, the latter being a function of the former. After peaking in 1989 and a brief resurgence in 1990, in 1991 Japan's stock market fell precipitously, and to this day it has yet to fully recover. On December 29, 1989, the Nikkei 225 closed at 38,915. It currently hovers just under 15,000, as of April 2014.

Japanese monetary and fiscal policy and the resulting economy and asset prices of the late 1980's and early 1990's are worth studying. In the US today, politicians and economists use Japan of that period as an example of where the US might be headed. The comparisons are not unfounded. A cursory review of government economic policies alone seems to support the comparisons between the two. Loose monetary policy in the form of lowered short term interest rates, an increase in the money supply (the US Fed has attempted to achieve this through the increase of its balance sheet) and Yen destruction are all similar to the US's policies of the past five years to combat the 'great recession.' In short, the US has lowered short term rates to basically zero, by doing so the US achieved a weak dollar policy to compete globally, and has additionally stimulated the economy through its quantitative easing policy (QE) of purchasing securities and therefore increasing the money supply (and its balance sheet) and injecting liquidity in to the economy.

Demographics: We're Different, Right???

Some of the arguments against the notion that we are headed for a Japanese style lost decade are based on the idea that the cultures of the two nations are not similar and therefore preclude the same outcome. To be sure, the most common example of this is observed in the savings styles of each culture. The Japanese are famous savers while Americans are famously not. There is a lot of credibility to this argument. While the Japanese are busy stuffing their mattress, Americans are at the mall. The obvious takeaway here is that while Japan's economy is suffering from the lack of a retail spender, the US economy is the beneficiary of rabid American consumer. However, to blindly accept this as gospel could lead to a gross miscalculation of how the US economy might claw its way out of its low growth dilemma. I would suggest the possibility of a changing American consumer, more like the Japanese counterpart. The catalysts of this change could be found in a slower job growth environment coupled with stagnant asset prices and a mild liquidity crunch.

In the past, Americans used the rising values of their primary asset, their homes, and eager lenders, to access that liquidity, to tap funds to fuel their desired consumption. As muted price appreciation and more conservative lending standards take hold, this avenue for funds is either reduced if not completely eliminated. In other words, Americans have no choice but to become Japanese, so to speak. Another comparison is the aging populations of both countries. The US's well publicized 'Baby Boom' generation is believed to be about ready to leave the workforce and pare spending in addition to consuming and investing less. This has been a major concern for Japan's economy for decades, as its aging population and low birth rate (1.39) combine to create a toxic cocktail of fewer productive workers and muted consumers. In addition to Baby Boomers the US does not have a robust birth rate at 2.0 and must rely on immigration to produce young workers. If the immigrant population were not to adopt American spending habits, it's possible that their contribution to the US economy would be limited to low wage workers and not significant consumers.

Every capitalistic economy's number one enemy is deflation. Too complex to delve in to here, just know that it can debilitate a capitalistic economy that is based on lending and credit to function not just efficiently but properly. In a nutshell, inflation, the opposite of deflation, degrades debt and justifies its use. Without it, debt is not as efficient a tool for financing. Japan suffered from deflation and has been battling it impotently since its market collapse in 1991. When prices started falling, the Japanese were happy to sit back and put off spending when they thought prices would be lower in the future. Economists don't believe this will happen in the US when they consider spending habits of American consumers. However, despite historically low interest rates, inflation remains muted, and below the Fed's target of 2.0%. This should indicate a subdued consumer, despite historical spending patterns by Americans.

So Are We 'Turning Japanese'? Maybe It Doesn't Matter!

The argument until now has been, are we destined to experience a Japanese style lost decade. Ironically, it could be that all of the arguments for and against whether the American consumer will be like the Japanese consumer and thus seal our collective fates, may not even matter because it may not be the causal effect. It could be that the factors that cause an American lost decade may come about as a result of US economic policies, both monetary and fiscal (in this case it's more of a lack of policy) that creates asset bubbles that pop and a liquidity crunch in the form of inevitably higher interest rates that limits credit and therefore past exuberant American consumption. In the case of Japan, the Bank of Japan was forced to raise interest rates to battle asset bubbles. In the US case it may the same forced hand of the Fed or some exogenous catalyst that causes rates to rise cutting of an endless rise in asset values, specifically equities. As of this writing, US equity indices sit at historic highs.

Note:

I have not addressed the fact that the Japanese economy is effectively self-funded (savers buy most Japanese debt) versus the US economy which sells its debt globally (Japan happens to be the third largest holder of US debt) because the US dollar acts as the international currency of global exchange and therefore makes for a complex analysis of the impact of either on each economy.

Why Tyrion Lannister Could Run Today's Fed

Outrageous title? Perhaps. Outlandish concept. Maybe not. As the Fed navigates it's waythrough the eventual complete taper of its unprecedented monetary stimulus, it will rely more and more on dialogue than blunt instruments, to achieve what it wants. This is where Tyrion steps in. Tyrion Lannister of Game of Thrones fame is superlative in using his wits and his tongue to manipulate to get what he wants eschewing physical violence when he can.

The Fed has adopted a guidance policy after having used quantitative easing to lift the economy out of one of the worst recessions in U.S. economic history. Unfortunately, to achieve its goals the Fed has increased its balance sheet from roughly $900 billion in 2008 to over $4 trillion today. And while the Fed is tapering, that balance is increasing as purchases will continue through year end. Having used monetary tools, the Fed adopted a forward guidance policy that relies more on using Fed statements and the language in those statements to guide markets and their participants while avoiding actual open market operations. With interest rates at zero and an inflated balance sheet, the Fed has little choice but to change tack.

What Could Tyrion Do For the Fed?

Tyrion has used blunt force to achieve his goals, but given his diminutive stature, he is wise to rely on more esoteric means to get what he wants. Not being particularly physically intimidating, it is more fearsome when Tyrion opens his mouth. How could this benefit the Fed? Toady's Fed, and specifically, Janet Yellen, will lean heavily on its zero-interest rate policy (ZIRP) to help guide markets. At its meetings and subsequent press conferences, the Fed will use language in its official statements and press conference dialogue to guide markets with its intentions regarding its Fed funds rate. Ms Yellen would be wise to mimic Tyrion in his attempts to shape kingdoms and influence outcomes of grand conflicts. Tyrion's big crutch is his family's wealth and his ability to cover what seem to be limitless debts. The Fed has even more limitless resources at its disposal and it is this lethal capability that it can hint at when intimating what it still can do to influence the economy and markets.

Tyrion would be less effective in his efforts if he didn't have the weight of his family's name behind him. Equally, if the Fed did not hold sway over instruments that affect global interest rates, it would be less effective in its policies. The idea that the Fed stands by ready to provide support in the event that the economy stumbles is enough to give market participants the confidence to invest and provide liquidity to the capital markets. The characters in George R.R. Martins' massive literary saga are compelled to behave and be manipulated by Tyrion as he tries to protect the realm and his family's position in it. Tyrion knows that he cannot go to war each time he encounters a conflict. Over time it would erode his credibility and resources and the demise of the Lannister reign would ensue. Diplomacy and subterfuge are Tyrion's greatest and most enduring resources.

Janet Yellen's Own Game of Thrones

For better or worse, Ms Yellen follows in the footsteps of one of the most scrutinized Fed Presidents of all time. It will be interesting to follow how Ms Yellen is treated in the wake of what Ben Bernanke faced as the President of arguably the most anticipated Feds of all time. There is print out there that Ms Yellen will be treated more tenderly as she is embraced as a mother figure to many. That may go a little far but the fact that she is well regarded and undeniably a woman is irrefutable. She does have the benefit of taking over the Fed at a time when the bulk of the heavy lifting is behind the Fed and a more hands off approach should be adopted. Ms Yellen is likely to preside over a Fed that is called upon less to save the U.S. economy and more to help soothe markets with its presence and accommodative posture. As Tyrion cannot survive constant war to protect the realm, Ms Yellen cannot exhaust the Fed's remaining resources ad infinitum and will rely on a more esoteric methodology.

Time To Revisit Housing and Affordability

Now that 2014 is well underway, we have gotten a taste of what life might be like with a less accommodative Fed and what those implications might be going forward on our markets, specifically interest rates and housing.

Does the Fed Taper Equal Weaker Equity Markets?

It seems the Fed is serious about sticking to its guns and moving forward with its plans to taper its quantitative easing program (QE). At the Fed's latest meeting, the Fed announced an additional taper of $10 billion bringing the reduction to $20 billion and the remaining amount of stimulus at $65 billion, down from its original $85 billion. Since the beginning of the year, the major US stock indices are down about 5%, with the Russell 2000 small cap index near correction levels, with a nearly 10% reduction from it's high, reached in late 2013. Are equities responding to a reduction in stimulus or is there genuine concern over weaker economic data in the US and wider global economy? Many pundits are claiming that weakness in emerging market currencies, weaker Chinese PMI equivalent data, and concerns in the Euro zone are causing markets to sell off. However, given the market's recent propensity to brush off all concerns leading in to 2014, it is hard to allow that the recent weakness in markets is due to weak economic data. More likely are the combination of money managers protecting sizable portfolio gains with an eye on a less accommodative Fed and the scary prospect of weakening economic data (January's employment figure was far less then estimated and employment claims have been creeping higher, reversing a downward trend) in the face of a less effective Fed. What are money managers to think if the Fed's tool bag appears spent and is unarmed to defend the economy from, not only weakening data, but a potential black swan shock (could this come from the trillion dollar student loan bubble?) These are legitimate and debatable concerns, and not just academic discussions, as equity markets are, indeed, selling off and displaying weakening technicals (trend lines are falling harder than German troops in a wintry Russian countryside).

Weakening Equites Contributing to Strengthening Bonds Resulting in Lower Yields?

As is often the case, fixed income securities can benefit from a weakening equity market as monies flow from equity portfolios to treasury portfolios in search of security. As treasury prices rise and their associated yields decline, most other fixed income securities follow suit, as their prices and yields are a function of treasuries. The correlation is not 100% but it's a decent rule of thumb. Why do we care? Because mortgage rates are priced off of the 10-year treasury bond, and this directly affects one component of housing affordability. One of the concerns heading in to the new year was the consensus of a rising rate environment in the US and its implications on the housing recovery. The Fed's zero interest rate policy (ZIRP) has remain unchanged and the Fed is steadfast in its resolve that rates will continue to stay low. This is a cornerstone of the Fed's policy of leading the market through use of its forward guidance and less with open market operations, allowing the balance sheet to remain contained. As a result, homeowners and potential homeowners can benefit as a result. In just the past week, average 30-year fixed mortgage rates have come down 10 basis points, or 0.10% (100 basis points equals 1.0%). Changes in rates like this can assist buyers as well as owners looking to refinance existing debt, relieving debt burden. Interest rates are likely to rise one day, to be sure, but equally important is the time frame by which they rise. Consensus opinion is that rising rates would not harm the nascent economic recovery if the rise was slow and consumers could acclimate to the higher cost of credit.
In an earlier post, I did the math for the impact a rise in mortgage rates would have on housing costs. Here is what I found: For a 30-year conforming loan amount of $417,000, the interest and principal payment would rise just over $29 with a rise in the rate by just 0.125% or 1/8 of 1.0%.  This does not sound all that impressive or substantial. However, to put this in to context, this rise would result in a loss of purchasing power of just over $6,400. In a declining rate environment, the opposite is true, these payments would fall accordingly and purchasing power would increase. These numbers reflect what occurred over just the last week. If the trend were to continue, housing does become more affordable, as long as prices do not have a corresponding rise. As the rise or fall in rates happens faster than prices move, this is unlikely to be the case, at least initially, particularly in the face of a weakening labor market.

Wealth and Income Inequality: What is to be Done?

This week, much will be written about the goings on and discussions that take place in Davos. This high powered gathering place serves as a platform for the ultra wealthy and not so ultra wealthy economists and professors to visit and discuss all manner of things economic. After years of stratospheric gains in global equities markets, the focus seems to have turned to what is to be done now that "we" are wealthier than ever, what can we do about the majority of world citizens that are being left behind? This is only a concern because obviously folks with no money or possibility of income struggle to consume the products that the "haves" produce. If the "have nots" don't consume it won't be long before the "haves" start to feel it. And what's worse is what happens when the "have nots" get really disgusted. It's called revolution and no one wants one of those. This is not hyperbole. The wealth gap is widening and the middle class is shrinking and at some point something's got to give. So what is to be done?

How Did We Get Here?

The Fed policies instituted since 2008 to combat the recession have contributed to the dilemma. By injecting massive and unprecedented liquidity in to the system to pick up the slack of reduced money velocity, the widening gap has been one unintended consequence of the Fed's actions. With the elimination of jobs to maintain profit margins, attrition due to technology, and the perceived lack of demand, US companies are not providing the jobs required to support a growing middle class. It is this growth that would mitigate some of the growing disparity between the wealthy and the rest of society. As a result, the injection of liquidity has found its way in to assets that are held mostly by the wealthy. This actually was intended. The desired result was a "wealth effect" that would stimulate the economy and start the "virtuous cycle" that would raise all boats. Unfortunately, this does not appear to have taken hold as of yet. There are certainly indications that economic activity has perked up and to no small part due to fatter stock portfolios and stronger balance sheets. However, this has not caused the uptick in hiring that is really needed to drive the economy higher.

Some Thoughts and Ideas to Combat the Gap

The easy answer and most widely discussed and applied approach is the tax approach. Tax higher income earners at a higher rate and apply those monies to social programs. There is no empirical evidence that shows higher earners will be dissuaded from earning more as they pay more in taxes. They simply earn what they earn and will keep as much of it as they can. Taxing passive income at higher rates is another tax approach that, in theory, hits the wealthy more as they own the majority of assets that produce passive income. Some example of these are rental properties, stocks and bonds, and other financial assets.
But taxing has proven to not be the best or most effective way to "spread the wealth" amongst the different groups in our social strata. There must be better ways to reallocate a portion of the wealth created in this country and around the globe, as this is truly a global issue. Bill Gates and George Soros can serve as examples of individuals who have taken a stand against social issues such as poverty, health care and education. We can use these folks as exemplar figures to be emulated. An organization like the Bill and Melinda Gates Foundation is a good example of something to be emulated and replicated on a global scale. The effort in this case could be to provide the education, training and hands-on experience that many citizens lack to achieve employment and become self reliant and productive members of a thriving economy. Employment agencies both public and private exist but are not sufficient or effective enough for one reason or another. The weakness of public run agencies is the overwhelming need and inadequate resources to provide help. The weakness of private agencies is the profit incentive creates an obstacle from all parties getting a "fair shake" when trying to get assistance. Directing philanthropic efforts towards employment in addition to the traditional philanthropic goals could help mitigate the growing gap.
On the other side of the equation are the corporations and companies doing the hiring. They need additional incentive to hire. Corporations cannot and will not hire just to hire from a  philanthropic perspective. They exist to make profits for their shareholders, they do not exist to create jobs for the sake of creating jobs. Labor is typically the largest cost component companies have. Some mechanism must exist to incentivize, or at least mitigate, the cost companies carry when confronted with the prospect of hiring additional staff. Economic uncertainty is a large obstacle companies face when considering when and how much additional staff to put on the payroll. Offering tax incentives for hiring domestically instead of overseas would help domestic economies and have the stimulative impact of improving the condition of consumers locally. The loss of these tax incentives for local governments could be offset by higher income taxes of the newly hired and creates a win-win solution.
The best, most productive and effective way to combat the growing income and wealth gap is to create more jobs and get the most important resource we have, the human resource, back to work. Simply taking money away from the wealthy and just giving it to the less prosperous is not the answer. There needs to exist a stimulative byproduct of the distribution of wealth.

Happy New Year - Where We Were and Where We're Headed in 2014?

First and foremost, Happy New Year to all. 2013 was a good year for equity markets and now it's time to briefly look back at what transpired in the economy and the markets and what may happen looking forward to 2014.

Where Did We End 2013?

The Dow Jones Industrial Average ended the year at 16,576.66, a rise of 26.50%, not including dividends, from the close in 2012. The Standard & Poor's 500 Index finished the year at 1,848.36, up 29.60%, not including dividends, from the close in 2012. The Nasdaq Composite closed the year at 4,176, up 38.3%, not including dividends, from the close in 2012. The Russell 2000 Small Cap Index closed the year at 1,163.64, up 37.0%, not including dividends, from the close in 2012. The 10-Year US Treasury Bond closed the year with a yield of 3.03%, up from a yield of 1.76% on December 31, 2012. The average 30-year fixed rate conventional mortgage was 4.18% in January 2012. Todays comparable rate is 4.69%. So 2014 is starting off with more expensive credit for homeowners and prospective homeowners. Real gross domestic product (GDP) growth in the fourth quarter of 2012 was 0.40%, GDP growth in the first quarter of 2013 was 1.80%, GDP growth in the second quarter of 2013 was 2.50% and GDP growth in the third quarter of 2013 was 4.10%. Fourth quarter and annual estimates for 2013 will be released January 30, 2014. Throughout 2013 the growth trend for GDP was upward. Inflation for the third quarter of 2013 was 1.80% after trending upwards through out 2013.

Where are Things Headed in 2014?

With the information above as a backdrop, where are the economy and markets headed in 2014? One of the biggest concerns expressed this time of year is can the market replicate the massive run it had over the course of the prior year? After such a strong 2013 for equities, is it realistic to expect additional powerful returns from the major indices? Most money managers will try to spin any positive they can from the momentum of the past. Further gains are certainly possible. Let's take a look at some trends that may guide us and some market milestones that may give us perspective and context for what may unfold going forward.
For context, it is important to note that in addition to gains of nearly 30% or more for each of the major equity indices, it is important to point out that all of these indices, with the exception of the Nasdaq, closed 2013 at record highs. This is important as it gives us some perspective on the resistance these indices might face moving forward and seeking further gains in the new year. I believe this is the singular reason many money managers are less sanguine entering 2014.
With many market experts attributing the gains in equities to easy money Fed policies, which we've touched on ad nauseam in this blog, the Fed's announcement to begin tapering its bond purchases at its December meeting was at least initially greeted exuberantly by markets. However, this reduction in monetary accommodation cannot be ignored for what it is: a subtle shift in stance away from accommodation and towards tightening. Most market pundits are not calling the Fed move  tightening. If it's not tightening, what is it? Less accommodation? Where does that lead? I believe the folks managing money in 2014 are quietly viewing this move as a tightening of sorts and their actions will speak volumes to this. Less liquidity will naturally lead to less exuberance  for gains in equities. With this tailwind reduced and ultimately eliminated, further gains in equities will require more solid underpinnings by market fundamentals such as earnings growth and more specifically, revenue growth. It will be corporate America's ability to produce this growth that will dictate how equities fare going forward.
The economic outlook is fairly optimistic. GDP has trended higher throughout 2013 and the latest GDP figures exceeded expectations pointing to upside surprises going forward. Corporations are broadly expected to make larger corporate expenditures in the new year. One line of thinking is that with less incentive to reinvest the existing corporate cash horde in corporation's own stock will mean more outside investment to grow business lines. Therefore the outlook for an improved labor market as a result of this investment is anticipated. Demand for goods and services should increase with a more robust labor market. This evolution can be thought of as the "virtuous cycle" that is often referenced in a healing economy. Equity markets lead the economy out of recession and this time around appears to be no different. The current economic improvement may be fully discounted by the markets and leave little to gain. This is a very real possibility and underpins concerns held by money managers hopeful for more gains this year. More than a few market pundits have suggested that markets have borrowed from future returns (the market's discounting mechanism at work).
One ironic concern of the market is that an improving economy can bring with it some unwanted consequences that may create headwinds for further equity gains. One of those consequences is rising rates. The 10-year Treasury yield climbed throughout 2013 and with it mortgage rates climbed as well. This is a natural result of an improving economy that, without the artificial hand of the Fed, would cause yields to rise. Rising rates can hold back some parts of the economy, specifically, the housing market. Rising mortgage rates may hinder homeowner's ability to refinance their higher rate loans and hurt the deleveraging process required for a healthy consumer. Will higher mortgage rates hold back further gains in real estate in 2014? This is a real possibility. A large component of a healthy consumer is their ability to leverage the value of their homes and access the capital markets. If real estate struggles for further gains in 2014 because of rising mortgage rates and banks do not relax their lending standards, homeowners will be challenged to maintain, let alone, increase their consumption habits. As consumer consumption makes up such a large component of the US economy, GDP and corporate revenues would suffer without a healthy consumer.

Looking Forward and Making Wild Guesses

Few stock bull markets last beyond five years. The average bull market lasts 3.8 years. In March of 2014, the current bull market turns five. History is not a perfect forecasting tool for future performance but at least this statistic gives us some perspective. Armed with this knowledge we can attribute some probabilities to the likelihood of the current market run to continue. Here are the factors I am considering when I think of the likely performance of the stock market throughout 2014:
"Goodbye Mr Bernanke, it's been real" Whether you prescribe to the Fed's influence on the stock market's performance or not, what is undeniably true is that the Fed has been accommodative and supportive of this market for years. What the Fed has not done is get in the way in any shape or form to hold the market back. At the least the Fed was never a headwind to the market. Rates have not only been held at zero for years but the Fed has gone out of its way to assure the market that rates will stay low for an "extended" amount of time (read: forever). Whether the Fed is technically still accommodative doesn't matter any more. Once the Fed announced its taper at the December meeting everything changed. Market strategists will always tell you, "it's not the numbers, it's the trend". Well, you can't have it both ways, the trend from the Fed is "less" accommodation and that's all that matters. For all intents and purposes, the Fed is not the tailwind it once was.
Interest rates and bond vigilantes. It is likely that we have seen the low in interest rates. Could we get back to record lows some day down the road, yes. Is it likely? When you consider how bad things would have to be for us to get there, I think we have bigger problems than what the stock market is doing at that point. No hyperbole there. The Fed may think it can control interest rates for the time being, but it cannot control them forever. Forever is a long time. The elephant in the room is the Fed losing control of interest rates. If for some reason inflation becomes a legitimate problem in 2014, market forces will take control of interest rates and the Fed will lose control of rates. Regardless, rates will rise throughout 2014 as the economy improves. Rising rates will be a headwind in 2014 and until the economy acclimates to these higher rates, consumers will be restrained for the reasons mentioned above, and consumption will be muted.
NO ATM for you! Despite the surge in real estate prices since the dark days of the recession, homeowners cannot use their homes as ATMs as they did in the past.(Values are not quite there and banks are not quite there) I think people underestimate how critical this was to how well our economy performed in the past. It may be anecdotal, but I see fewer boats and RVs in driveways today. Despite what will likely be a healing labor market, the additions to the payrolls is not likely to add significantly to consumer consumption as thousands of the unemployed roll off unemployment benefits.
For these reasons alone I think market performance is muted in 2014. On a net basis, ignoring hims and haws throughout the year, at best the market will likely close flat for 2014. Specifically, the Dow will close 2014 at 16,500 and the S&P 500 will close at 1,850. The 10-year treasury will yield 3.75%.  GDP will be respectable for 2014 and labor markets will improve. In essence, my belief is that the market has borrowed from the future and will play catch up in 2014, taking a much needed breather. The fun part of guessing is we get to sit back and watch things unfold. Good luck in the new year!

With Taper Tantrum Behind Us, Can Good News Be Good News Again?

At its December 18 Fed meeting, the US Central Bank announced its plans to start tapering back its policy of purchasing treasuries and mortgage backed bonds commonly known and referred to as quantitative easing or QE. Starting in January the Central Bank will reduce its purchases of these securities to $75 billion a month, a reduction of $10 billion. Based upon a slowly recovering economy the Fed's intent is to announce a further $10 billion reduction at each of its eight meetings in 2014 which would result in eliminating the program altogether. As markets have relied on the stimulus program to support asset prices, potential withdrawal of the program was greeted with a certain amount of apprehension creating an environment where bad news was received positively by markets and good news was not so well received. A fair question is: As Fed policy normalizes in 2014 will the markets reaction to good and bad news do the same?

Good News is Bad for Asset Prices

Financial markets can be unpredictable and fickle things. One of the great conundrums of the last five years has been the notion of markets responding counterintuitively to economic data. The market participants that performed the best during the financial recovery were those who embraced the notion that weaker data would encourage an accommodative Fed which would provide more and more stimulus. This position required an iron constitution to accept and anticipate counterintuitive market behavior to varied economic data. And market behavior proved to be very unpredictable. In addition to being an "unloved" bull market by most investors, the equity market's rise was widely resisted as retail investors avoided equities while professional money managers resisted as well as shorted equities, which was a truly losing cause. The most disastrous results were from those managers who could not adapt to the idea that bad was good or good was bad. For tenured managers this shift was too overwhelming to acknowledge. Headlines of failed hedge funds littered the financial press each and every week for years. Predicting market behavior became first anticipating the data and then forecasting the market's response to that data, which is not a new concept but now it had a new twist. The only thing more bizarre than the market's response to data was the media's portrayal of how the market would react to data. End of month labor reports became circus-like with the multitude of analysts and professionals that CNBC and other financial programs would trot out and interview. All of the analysis and pontificating was based on a notion that weak data would keep the Fed on hold from removing liquidity from the market and helping maintain the bull market. The biggest fear became a large and positive labor report.

With the Fed's Decision to Announce the Taper, is it Time to Shift the Thinking Again?

Will the most successful money managers in 2014 be the ones that can go back to the old school way of interpreting economic data? If so, how and when will we know how the market is responding to the data? How many data points will we need to spot a trend? Based upon the equity market's reaction to the Fed's statement, it seems the market is ready to embrace good economic data again and reward the markets accordingly. To be sure, the reference to markets is equities, not all asset classes. Commodities such as gold have already weakened significantly and fixed income have suffered as yields have started to climb again after falling briefly. There was much revelry when yields did not skyrocket with the Fed's announcement. I think much is being made about this, when in reality, why should we be so confident that rates won't take their good old time to start to rise? One reason investors might point to a subdued yield environment is the fact that the Fed seemed very concerned about inflation, and more specifically, the lack thereof. The one thing that may scare the Fed more than good old fashioned inflation is not so good old fashioned deflation. As few outside of an economics classroom appreciate, deflation is truly a worrisome concept. In a nut shell, consumers stop consuming in anticipation of lower prices and the mechanics and benefits of debt break down with deflation. For a culture and society that lives for debt, this is debilitating. Japan in the 90s is the case study of deflation. Trust me, it's worse than inflation.

The Fed Soothed Markets By Assuring Them of Low Short Term Rates Forever (Hyperbole)

One of the things the Fed would like to accomplish is an ability to soothe markets more through guidance and commentary than through actual action. If the Fed is successful, it can accomplish its intended goals of assisting markets without the fear of unintended consequences of increasing its balance sheet. If the market accepts this approach and acknowledges the Fed's accommodative position, then good economic data can be interpreted as good for markets and vice versa. This can happen perhaps because without the market actually performing quantitative easing, the market can move away from the fear of losing stimulus and accept good news for what it is, an improving economy which should lead to improving financial markets: higher equity values and normalized interest rates.

Ironically, As Equity Markets Are a Discounting Mechanism, is There Remaining Upside?

As money managers are wont to do, equity forecasts for 2014 are naturally upbeat. Most range from modest, if any, growth, to the sublime of an additional 20% on top of 2013 gains. However, given the growth in equity values to date versus the modest GDP growth in the real economy, is good economic data just doing "catch up" leaving the equity markets flat in 2014? With most managers at the least acknowledging a fairly priced equity market, what room is there left for further short and intermediate term asset value growth? If equity markets continue to function as they always have, the improving economy has been long since priced in to todays values. Maybe what the markets are left with is that good news is just a sigh of relief and not an exultation or catastrophe.