Market Update 6 30 11 _ Austerity begins

Austerity

 

My son is eleven years old, and while he is certainly very helpful around the house he is still what I would term a source of negative cash flow.  As such, I was surprised to hear that he was expecting some serious perks on a recent trip to the barber shop.

 

A few weeks ago he went for a haircut with his uncle to a sports-themed barber shop here in town.  They've got some flat screen TVs and there is always a game on...it’s a pretty good gimmick for a barber shop.  While they were there his uncle treated my son and his cousin to the barber shop’s “VIP Package”.  This is a deal where you not only get your haircut but you get a hot towel on your face while they give you a shoulder massage.  As it turns out the kids loved it...and they now expect it.

 

A few weeks later it was time for another haircut.  When my wife told me that my eleven year old was wanting the VIP package at the barber shop I stared blankly at her, then I asked her what that meant.  When she explained to me what the VIP Package was (and then to my astonishment re-confirmed that my son really was expecting this treatment), I almost fell out.

 

My recollection of the barber shop when I was his age was of getting my hair cut by a balding, cigar-smoking old man who I prayed would not lop one of my ears off with his incredibly noisy and painfully sharp shearers.  Nowadays kids want/expect a hot towel on their face and a massage.  Ha!  This was going to be a fun talk.  I figured an early reality check would be a lot less painful for him than letting this VIP stuff go on for months before putting the brakes on it.  I took a moment to explain to the child that the haircut is on me but if he wants the VIP Package he’ll have to use his personal funds for that.  It was the last I heard of the VIP treatment.  I assume that after a brief analysis of his statement of cash flows he decided that he’d rather use his allowance money for purposes other than a hot towel on his face.  This simply reinforced in my mind that people like free stuff…risk free perks.  When you have some skin in the game…the decisions are sometimes made differently.

 

I’m not the only one dealing with austerity issues now-a-days.  Greece has had two votes this week to decide if, and how, they will implement their own austerity measures.  To receive financial assistance from their European neighbors Greece needs to reign in some of their financial excesses.  Yesterday they agreed that the austerity plans must begin, today they voted on a package of how to start.  In other words, yesterday they agreed that people were going to get hammered, today they decided who and in which order the hammering would begin.  There are more riots in Greek streets as the “hammerees” voice their displeasure at having their perks taken away.  Clearly there will be a lot of friction as people see their standard of living cast in doubt. 

 

The markets

 

The markets on the other hand like the outcome of the votes.  As we’ve discussed in the past, there is a lot of money parked in Treasury bonds as a result of fear over the Greek situation.  As investors struggled with the probability of a sovereign default in Europe they drove a “flight to quality” trade that pushed US Treasury yields to recent lows.  While the US certainly has its share of fiscal issues we are still a great place to park your cash when there is trouble on the horizon.  The last two days have seen a bit of a reversal of that flight-to-quality trade.  As investors see solutions being implemented they begin to get more comfortable putting money to work.  At some point they become comfortable enough to sell their Treasury holdings (or avoid purchasing more at the auctions) and reinvest in areas that were too scary to touch while a sovereign default was stalking the markets.  As a result we’ve seen the 10-year Treasury move up 30 bps in yield since last Friday’s level of 2.88%.

 

This would normally be a quiet week for the markets as we are rolling into a long holiday weekend at quarter end/month end in the middle of the summer.  Contrary to the quiet week that we might expect we have the 10-year Treasury trading up to a 3.18%, the Fed wrapping up QE2, and Greece initiating austerity measures.  There is no shortage of factors that might upset the markets. 

 

As we head into the weekend we are seeing that austerity is the new thing.  Luckily for me my eleven year old is the rule-following type…there were no riots at my house over the suspension of his barber shop VIP Packages.

 

If you have any questions or if there is anything I can be doing for you just let me know. 

 

I hope you have a great Fourth of July.

 

Steve Scaramastro, SVP

800-311-0707

 

 

 

 

 

Market Update _ The Fed and their "extended period"

FOMC

Here is the quick story: recovery continues (albeit more slowly than we thought), jobs still stink, QE2 will end on time, we’re not thinking about QE3, we’ll keep reinvesting the cash flows from our portfolio, our forecasts for growth are now lower, we expect things to pick up in coming quarters, and rates will remain exceptionally low for…wait for it…here it comes…you can guess it…an extended period of time.   If you don’t have a lot of time you can go back to work after reading this first paragraph…you now have what you need to know about today’s meeting. 

Extended Period

Bernanke has been asked in the past what “Extended Period” means.  It came up again today and he repeated his earlier thought that the phrase means “at least two or three meetings…but depending on the data it could be considerably more.”

On the surface his answer sounds pretty good…”extended period” equals two or three meetings.  There are eight meeting per year so “two or three meetings” means less than half a year.  That math is so easy a caveman could do it.  Where it gets complicated is that they have been saying it for almost two and a half years.  At some point I have to question what they’re really thinking. 

I’m reminded of the scene from the movie “The Princess Bride” where Vizzini (the main villain) is counseled by one of his comedic sidekicks.  Every time something bad happens, Vizzini exclaims in his high pitched nasally voice “Inconceivable!”, because in his mind he is so smart that nobody could possibly outwit him.   After this happens five or six times, his sword-fighter Inigo Montoya (one of his comedic underlings) approaches him and says to him in his Spanish accent “Señor, you keep on using this word…I do not think it means what you think it means.”  This scene sums up where I am with the Feds “extended period” language.   If you’re telling me that “extended period” means two or three meetings…but here we are two and a half years later and they’re still using it…I don’t think it means what they think it means. 

The phrase “extended period” is beginning to take on the connotation “we have no earthly idea when we’ll be able to raise rates.  I understand that they can’t come right out and say in explicit terms that they’ve no earthly idea when things will get better…maybe I’m just wanting a bit of variety in the way they give me the news.  After all variety is the spice of life…but the Fed keeps giving me the same bland phrasing every six weeks.

I’ve got half a mind to go home and watch “The Princess Bride” tonight, but last night during our wrestling match the dog knocked my beer out of my hand and I don’t think either one of us are allowed back in the living room for “an extended period”.

Steve Scaramastro, SVP

800-311-0707

 

 

Market Update Friday afternoon _ Everything is dragging on

 

I saw a headline a few minutes ago saying that Libya’s Qaddafi doesn’t intend to resign.  Resign?  NATO has been fighting this third world dictator for weeks and they STILL haven’t kicked this guy’s butt yet.  I promise that if you gave me one stadium full of European soccer fans and a beer truck I could have ended this Libya thing in three days time. 

 

It seems like lots of things are dragging on lately.  The problems in Europe continue to affect the Treasury market week after week.  The economic data in the US continue to come in poorly week after week.  The Fed continues to hold their position that rates will remain low for “an extended period”.  As some of you are aware even my boat has been in the shop week after week…I’m ready for a change.

 

Six weeks ago the 10-year was trading at a 3.20%, today the 10-year is heading into the end of the week at a 2.94%.  This marks the 5^th consecutive week that the 10-year has ended the week at a lower level than it began (feel free to use that fact for Friday afternoon office trivia).

 

Maybe we’ll see some improvement next week.  There seems to be some headway in finding a “solution” to the Greek debt crisis.  If this happens we should begin see a reversal of the flight to safety trade that has hammered Treasury yields lower over the past weeks and months.  This would ease some of the pressure on bank portfolio managers that are trying to get money to work in this environment. 

 

Next week is looking up already…the shop just told me my boat will be ready Monday.    

 

If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707

Market Update _ When Bernanke speaks...people listen

Today’s episode of government efficiency

A failing, uncompetitive GM has been receiving taxpayer money for the last two years.  NASA is having their budget cut at the same time.  My last GM product made it about 70,000 miles before it broke down.  I read today that NASA’s Voyager 1 vehicle is currently 11 BILLION miles away from earth...and still working fine.  It would appear to me that if we are going to give anyone money to be making vehicles…it should be NASA…not GM.

On to more relevant matters

Bernanke speaks

Chairman Bernanke gave a speech on monetary policy to the International Monetary Conference today.   For those of you that like the short story here it is:

The job market stinks, there is no inflation, don’t blame the Fed for rising commodities prices, and we’re keeping rates low for a long time.

You can stop reading right here if you are a “just give me the short story” type of person.

For those that want more detail…read on…

The song remains the same

Much of what Bernanke had to say today has been said ad nauseam for the past two years.  There are too many people unemployed, and too many have been that way for too long.  Housing is in terrible shape.  Individuals are reluctant to spend due to all of the pressures they face.  Who wants to go blow a bunch of cash on a new TV when they know they could lose their job tomorrow?   I love a big screen TV as much as the next guy, but they don’t work too well when you’re forced out to curb.  Housing prices have fallen and become more affordable…but the pool of qualified buyers has shrunk tremendously. 

The Fed sees a modest recovery underway that was hampered in first quarter by a major disaster in Japan and rising fuel costs.  Fuel costs get a lot of attention but Bernanke points out that of the inflation that has shown up recently most of it is attributable to one item…gasoline…and that they expect this to be a transitory issue.  The Feds outlook is that gasoline prices will moderate later this year and help fuel growth (no pun intended). 

He is somewhat positive on the business sector.  As many have noted this year, business spending on equipment and software has been expanding.  Firms associated with the export industry have one well. 

With regard to the construction industry just envision him putting his palm to his forehead and mumbling something along the lines of “don’t even get me started…”  The housing market is in bad shape and will likely remain that way for a while. 

There’s no crying in central banking

Bernanke’s speech was 15 pages long.  I don’t say this to try to get some sympathy for having to read a 15 page paper on monetary policy…well…I might want a little bit of sympathy…but the main point is that of the 15 pages….a full 6 pages of it were dedicated to discussing commodities prices.  Why spend so much time on commodities prices?

It’s always interesting to hear a discussion on the determinants of price performance in the global commodities markets.   My wife can wait for me to come home each night with new and exciting stories about emerging markets impacts on global copper supplies.  I’m kidding of course…my wife has to use 30 thousand words per day…there is no room in the traffic pattern for my commodities discussions.

Bernanke on the other hand had a lot of room for commodities discussions.  He essentially said that emerging market demand along with failure of supply to keep up is the main culprit in the meteoric rise of prices.  Furthermore he insinuated that these countries need to stop crying about our domestic monetary policy being to blame for their inflation woes…they each have their own central banks who could…and should…be doing something about their issues.  They have the tools necessary…they just need to act.

He went on to point out that while the Feds activities have caused some erosion in the foreign exchange value of the dollar that their policies have not had a material impact on commodities prices.  While it is true that a drop in the value of the dollar causes dollar-denominated assets to rise in price, the rate at which the two have moved is not highly correlated.  George and I did the same math one day here in the office…if the dollar is off 15% and oil is up 160% it becomes very difficult to argue that the dollar’s drop is causing oil to rise.

Furthermore he points out that monetary policy is not the only factor that affects the FOREX value of the dollar…this fact will reduce even further the impact the Fed has had on commodities prices.

Bernanke concludes:

·         Recovery proceeding at moderate pace

·         Job situation far from normal

·         Inflation up some but should moderate

·         Conditions likely to warrant exceptionally low levels of Fed Funds Rate for extended period

·         Economy still producing well below its potential

·         Accommodative policies still needed

·         Won’t consider recovery sustainable until we see “sustained period of stronger job creation”

So…get used to low rates.  The end. 

If you have any questions or if there is anything I can be doing for you just let me know. 

Steve Scaramastro, SVP

800-311-0707

 

Market Update 6 6 11 _ Middle of the road

The Fed is getting squirrely

The mercury pushed up toward 100 degrees in Memphis yesterday, and the humidity seemed determined to keep pace.  It can get so oppressively hot in this part of the country that people just go inside and stay there when the sun is high.  I joked to the wife last week that this must be one of the few places where you can occasionally have a legitimate fear of dying of thirst in your own front yard.  These are some of my favorite days though because it means I’ll have all of the local mountain biking trails to myself.  There will be no crowds at all and I can fly through the woods with very few distractions. 

It was on one such ride yesterday that I saw what might be an omen.  We’ve all seen squirrels wrestle with the “do I run left or do I run right” dilemma.  This usually occurs as you barrel toward them in your car.  It’s easy to see how the squirrels have a tough time with the decision.  They have eyes only on one side of their head and the car is coming pretty fast…maybe it looks different out of one eye than it did the other…this way…no that way…and so it goes until it becomes a very close call. 

Well yesterday on my afternoon ride there were a ton of squirrels on the ground.  To my surprise the squirrels had some trouble with the “left or right” dilemma even with threats moving as slowly as me on a mountain bike in 100 degree heat.   Some of this I figure was due to the fact that they are in a state park…they are used to seeing lots of people and maybe they get complacent about the magnitude of the threats they face.

Squirrel after squirrel darted back and forth in front of me as the miles went by.  Ultimately though, one squirrel took far too long deciding if it would be “left or right.”  Indecision paralyzed this squirrel as he darted back and forth in a tighter and tighter range until it was too late.  It was left, right, left…and then right into the path of my bike.  As he went under the front tire I realized that I just joined what must be a very small group of people in this world…people who have run over a squirrel while riding a bike.   What struck me most about the deal was that he not only got hit squarely by the front tire, but that he bounced off the chain, and then got the rear tire as well…it was an abrupt and  pointed lesson on the dangers of complacency and indecision.

As I finished my ride I couldn’t help but compare the squirrel’s dilemma to that of the Fed.  Both have to make some big decisions, both have to be timely in their decision making, and both can get run-over if they stay in the middle of the road for too long.

Where are we now?

The Fed has put itself in a precarious position.  Short term rates are at zero percent and the Fed’s balance sheet has swollen to well over $2 trillion over the preceding two years. 

Our current situation is one where core inflation is low, unemployment is stubbornly high, and there is a very modest recovery underway.  The risk the Fed has feared most is tightening too soon and choking off a blossoming recovery before it has a chance to get deep roots.  On the other hand…if they don’t act soon enough and they let inflation get out of control they could do real damage as well.  The Feds “too early/too late” dilemma isn’t much different than the squirrels “left/right” dilemma. 

We know that they can’t/won’t wait until unemployment is significantly reduced and inflation is off to the races before they tighten.  So the question is “when will they do it?”

Several Fed officials have given us guidance recently.  Most recently the Minneapolis Fed President (Kocherlakota) and the Philadelphia Fed President (Plosser) have given us some color.  As we discuss this issue keep in mind that there are two ways that the Fed can “tighten” monetary policy.  The first is to simply raise the overnight rate.  The second is to monkey with their balance sheet via selling securities or by simply halting the reinvestment of portfolio cash flows.

When will they tighten?

Kocherlakota (Minneapolis) said recently that his forecast is for PCE (the Feds preferred inflation measure) to be at 1.50% and for unemployment to be 1.00% lower by year end (as a point of reference the unemployment rate ROSE to 9.10% on Friday so this one isn’t going his way at the moment).  He went on to say that if his forecast is correct then he would argue for a 50 bps increase in the overnight rate.  His statements were more long winded and full of caveats and cautions regarding the problems of forecasting such things but he at least put some numbers on the board for us to look at.

Plosser (Philadelphia) began discussing his thoughts on tightening back in the 1^st quarter.  In a perfect world Plosser would like to see the Fed Funds Rate regain its role as the primary tool of monetary policy.  To achieve this goal the Fed would have to shrink their balance sheet tremendously.  In his 1Q speech he provided a look at how this shift might look if executed over two time frames.  The first was a 12 month window and the second was over 18 months.  Reviewing that data is beyond the scope of today’s update but if you would like to see it just let me know and I’ll shoot you the Powerpoint presentation where we reviewed the plan.

More recently Plosser has said that “somewhat tighter monetary policy is possible by the end of the year”.  He acknowledges that the Fed will have to begin reversing course on monetary policy before all of the data look good…and that’s not a huge surprise.  Nobody expects that the Fed will wait until the Unemployment Rate is back down to 5.00% before they decide “OK…now it’s time to tighten.”

What to expect?

This talk from the Fed is very preliminary.  As a counterpoint to the items we just discussed we should consider last week’s statement from St. Louis Fed President Bullard.  He noted that there is historical precedent for the Fed going on hold and staying on hold for a long time period.  So while there is talk among some at the Fed about tightening policy, there is plenty of talk on the other side about sitting still. 

In my opinion the Fed will let QE2 expire and then sit back and watch the data for a few months.  They will want to see if there are any adverse effects from their departure from their role in that market.  If the data are positive over that time frame we’ll hear more chatter amongst the members as to which way to go.  This is not going to be a quick process…certainly not fast enough to make you feel better if you are sitting on a lot of cash…that should still be a fairly painful position as short term rates are likely to remain low for quite some time.

It’s very easy to see the first step in this process being the halting of portfolio cash flow reinvestment.  This is a great way to test the waters because it’s a passive move.  It shouldn’t be terribly alarming to the markets and it’s probably going to be the easiest thing to get the FOMC to agree upon.

If the markets don’t freak out over the move then you can begin a very well communicated plan to begin selling assets at a pace that the market can digest.  This will be the first big step toward restoring Fed Funds to its role as the primary tool of monetary policy.  If we get to a point where PCE is rising toward 1.50% to 2.00% then you should expect to hear a lot more talk about a hike in the overnight rate.  Several Fed members have gone on record as saying that inflation will not be tolerated…even if it means raising rates with a high unemployment rate. 

So today we have some very early discussions that are beginning to nudge the FOMC in two directions.  How they proceed will depend entirely on the data…but at this point I can only hope that they are better at zigzagging than yesterday’s squirrel.

If you have any questions or if there is anything I can be doing for you just let me know.

Regards,

Steve Scaramastro, SVP

800-311-0707