The guns have been fired. We wrote two weeks ago not to bet against Bernanke and the FOMC instigating another program of quantitative easing – the chairman’s speech from the annual Jackson Hole monetary symposium took pains to stress employment as a basis for further action, and the Fed is mandated to undertake policy that promotes employment. Not only did Uncle Ben lay the legal groundwork against his critics, but it sounds much better for a Fed chairman to say that the bank is working to improve employment, than to say that the economy looks like it is ready to suck for the rest of the year.
Many were against the action, ourselves included. Our concern is that the central bank now has almost nothing left in the arsenal against a rainy day. If some untoward event were to occur, ranging from the “Grexit” to disaster in the Middle East, the Fed is essentially now out of bullets. Offering to double or triple up on asset purchases would probably only frighten the bond (and currency) markets and raise yields instead of lowering them.
Bernanke did say during his press conference that monetary policy is not a panacea, and cited the situation in Europe at least twice (to our recollection) as a significant headwind. It’s a valid question as to whether or not he acted in concert and consultation with the European Central Bank (ECB) and its president, Mario Draghi. Draghi ignited the markets the previous week by pledging “unlimited” bond purchases. Unlimited but not unconditional, and Spain and Italy have already both indicated that they aren’t inclined to pay the application fee.
That may change in time, depending on the recession and politics. We may not find out for years if the bank chieftains acted in concert or merely in sympathy. It’s plausible that Draghi’s pledge encouraged Bernanke against the chance of a disorderly European crisis, or that Draghi made his pledge because he knew that Bernanke was going to institute another round. What really matters are the consequences.
To begin with, the equity and commodity markets love it, for now. Perhaps even a little too much, as veteran observer Mark Hulbert noted on Friday. Hulbert compared the current attitude with the bullishness of September 2008 and was discomfited by the parallels and how bullish prominent strategists were, not to mention wrong about the economy, regardless of the Lehman fallout. We wrote in Seeking Alpha last week about the parallels between now and the fall of 2007, when the Fed’s “monster” rate cuts drove the equity markets to an all-time high, yet weren’t enough to stop the oncoming U.S. recession.
The Fed is going to buy mortgage-backed securities (MBS) at a clip of $40 billion a month, indefinitely (hence the nickname, QE-infinity). This will pressure mortgage rates, already at record lows, and more importantly add to the money supply. We say more importantly because mortgage eligibility is the main issue for most people, and indeed the initial result of the program will be that the wealthiest will obtain the lowest rates in their lifetime to purchase a home, while those in the middle will generally find that nothing has changed.
Another immediate consequence is that interest rates have backed up again. Indeed, one prominent fund manager, Jeff Gundlach, predicted that the 10-year Treasury bond, a key benchmark, could rise a full 100 basis points between last week and year-end. Rising yields will encourage money to seek a home elsewhere, such as in equities and commodities.
The unknown that keeps the many managers and economists who are skeptical about the genuine impact of the new program from speaking against it is the wealth effect. The economy is slowing, but what if the market keeps rising and induces a key burst of confidence here and there? It’s a very gray area. Expectations in Europe are low enough that even a mild bout of restocking could further excite markets. How much will it excite business remains to be seen. The weakening dollar should be an export benefit, but China and Europe are more interested in selling than buying right now.
We think that the transmission to commodity prices is going to be faster than any wealth effect, and that the mere lowering of 10-year yields under threat from Mr. Draghi hasn’t changed the business dynamic in Europe or created a single job. Any attempt at public spending stimulus by the countries in greatest difficulty, Spain and Greece (measured by unemployment rates) will be met with strenuous opposition from Germany if it’s expected to foot the bill. Not forever, perhaps, but in the near term. Monetary policy doesn’t create industrial demand, but it can inflate asset prices.
Right now equities are technically quite overbought, so a bit of consolidation is in order. Given that it’s options expiration week, though, there should be some sort of bid under the market to keep things from getting out of hand. We still expect a top in October, because earnings and guidance are going to disappoint again, and this time there is no carrot of new central bank easing to distract traders. The best thing that could happen to the markets now would be for Europe to stage another rescue of Greece from the brink of default at least one more time before the end of the year. That’s always good for a floater.
The Economic Beat
A sure sign of a runaway bull market is when the big news of the week is some improvement in a sentiment survey, in particular the consumer variety. It’s circular logic – when the markets rally, consumer confidence goes up, and the markets in turn validate their rally by pointing to the consumer confidence number as evidence that it’s well-founded. The University of Michigan’s sentiment index rose more than expected on Friday, and was eagerly embraced by a market needing some legitimacy in the wake of two disappointing reports of hard data.
The business press helps push things along in such matters by enthusing about the great sentiment numbers, though when they are falling, commentators are usually quick to point out that they do not correlate well with spending (true). It is what it is; the national small-business confidence index also moved back up 1.7%. Probably the best story of the week so far as the economy goes was an increase in small business loans reported in the Wall Street Journal.
We thought that the most interesting report of the week was August industrial production, which was surprisingly weak across the board and fell overall by (-1.2%). Since the report is prepared by the Federal Reserve, it’s quite possible that Bernanke and the rest of the FOMC knew something about it during their meeting.
Hurricane Isaac was estimated to have shaved three-tenths of a point off the number, and was part of the reason that the data was largely given a free pass by traders. Manufacturing fell by (-0.7%), though, and industrial capacity fell to its lowest level of the year. It wasn’t just the hurricane.
But there is a silver lining, in that the sharp drop in the lumpy category of utility production should reverse in September. Along with the normal rebound effect from the hurricane, it’s quite possible to imagine a flattering rebound in industrial production that could be taken as positive evidence of the recovering economy and the Fed’s new policy, despite the fact that the bank would be too embarrassed to claim so quick of a reaction. Markets ignored the August drop, but are a good bet to celebrate the September rebound.
That Isaac played a limited role in the decline was suggested by the data for July wholesale sales (which fell 0.1%) and an unwanted increase in inventories of 0.7%. The year-on-year rate of increase in wholesale sales has been falling almost continuously for the last year and now sits at 2.7%, not much higher than the rate of inflation. Growth has slowed, and the FOMC cut its outlook for 2012.
The other big report on Friday was retail sales. It was an unexciting result, short of expectations and with a downward July revision. The overall increase of 0.9% made for a nice-looking headline, but excluding autos and gasoline, sales were only up 0.1%, at best equaling the rate of inflation. The increase in gasoline sales was strictly price-related too, as domestic demand continues to weaken.
The run-up in energy prices – tracking equities all the way – made for a 0.6% increase in the monthly consumer price index, and a 1.7% increase in the producer price index. The latter was also pushed by soaring food costs, which will begin to show up in the grocery aisles this month (partly with yet another downsizing of unit portions – i.e., the same prices for smaller boxes). During his press conference, Chairman Bernanke did not answer a direct question on the relationship between fresh rounds of quantitative easing and increases in energy and food prices.
Look for record gasoline and heating bills this winter. Import (+0.7%) and export (+0.9%) prices also spiked last month, also due to food and energy. Ex-energy import prices continue to softly decline, an indication of weakening demand.
The Census bureau reported that median household real income fell for the second year in a row, and is still below levels of a decade ago. That should go well with the rise in food and energy prices.
Turning to next week, we’ll get the first big batch of manufacturing survey data for September. New York leads off on Monday, followed by Philadelphia on Thursday. Housing should dominate the headlines, though (especially since it is more likely to look good), with the homebuilder sentiment index on Tuesday and housing starts and existing home sales on Wednesday. There are also the leading indicators on Thursday along with the “flash” PMI, but the market doesn’t heed them much; the flash PMI for China Wednesday night should get more attention.
Friday is a quadruple witching day. That may be the biggest influence of the week – absent political trouble, look for a steady floor under prices.