Faithful readers of our weekly Market Commentaries know that we have not agreed with the Fed's ultra-aggressive monetary policy. In our view, the purchase of trillions of dollars in Treasury bonds and mortgage-backed securities (MBS) has put the central bank in the difficult situation of having to extricate itself from these markets without causing major disruptions.
As we all have seen in recent months, the mere suggestion of a possible "tapering" in Fed asset purchases has caused a fire sale in Treasuries, MBS and other types of fixed-income securities. For all his good intentions, Bernanke's monetary experiment has caused a misallocation of resources, frothy asset prices, and a dangerous addiction to cheap money. The Fed should begin the process of normalizing the markets as soon as possible.
Indeed, while there are still some questions about exact timing, we do believe that the Fed is beginning to understand its predicament. More and more Fed members have supported the notion that the pace of bond purchases should slow by the end of the year. The minutes of the latest Fed meeting (July 30-31) said the following: "... if economic conditions improved broadly as expected, the Committee would moderate the pace of its securities purchases later this year." While the statement included a qualifier, we believe that the statement will serve as the Fed's "red line". Like Obama's red line with Syria over chemical weapons, we believe the Fed may have committed itself to action even though its own conditions for doing so have not really been met.
Consider the following developments over the past few weeks:
•The yield on the 10-year Treasury and the average rate on a 30-year mortgage are both up well over 100 basis points from their lows;
•New home sales plunged 13 percent in July compared to June;
•While the unemployment rate is down to a recent low of 7.4 percent, the U-6, or underemployment rate, remains at a very high 14.0 percent.
•Most of the recent job additions have been part-time jobs, and the labor force participation rate remains exceedingly low at 63.4 percent;
•Growth in personal income and personal spending slowed to an anemic +0.1 percent pace in July;
•The Fed's preferred measure of inflation, the core PCE, came in at 1.2 percent again in July -- well below the Fed's target of 2 percent;
•A wide variety of retailers offered disappointing guidance regarding sales prospects in the second half of the year;
•There is likely to be a limited bombing campaign in Syria in response to the use of chemical weapons;
•The price of oil has risen dramatically since June in response to geopolitical concerns;
•Uncertainty abounds with regard to US fiscal policy (debt ceiling, budget battle, sequestration);
•The Federal Reserve will likely welcome a new Chairman next year;
•Emerging markets are experiencing dramatic capital outflows and currency-weakening largely in anticipation of Fed tapering.
To the extent that the Fed's tapering is "condition-dependent", we'd have to say that those conditions are not very obvious to us. There have certainly been some green shoots in the economy, including rising home prices, lower weekly jobless claims, higher consumer confidence, and expansionary readings from the Institute for Supply Management indices (both manufacturing and non-manufacturing). But it is not clear whether or not this improvement is sustainable in the face of sharp interest rate increases, higher energy prices, and the rising risk of geopolitical shocks. In fact, we'd say the early indicators reveal that the recovery is not so resilient. The sharp drop in new home sales, weak spending in July, and negative guidance from retailers suggest to us that the recent rise in borrowing costs and energy prices may be starting to take a toll. Will the Fed take this data into consideration? Why taper if you are simply going to reverse course?
This is the conundrum that Fed policy has spawned. Rather than endure a normal (albeit deep) downturn in the business cycle, the Fed chose to moderate the pain while in the process extending its duration. It is hard to tell how long this period of "new-normal" growth will last, but we surmise that we'll be dealing with it for the next several years. From a 10,000 foot view, it should be apparent to all that the answer to the problem of excessive debt is not to encourage more debt. If only it were so easy!
Peace,
Michael