The End of Spring


“In the spring, at the end of the day, you should smell like dirt.” – Margaret Atwood

Mr. Bernanke continues to surprise us. The markets didn’t like what Chairman Ben said last week, but I have to give him a round of applause. After making a case in last week’s column that the Federal Reserve Bank needed to start pulling back from bond-buying, I then guessed that the FOMC (Fed monetary policy committee) would nevertheless soft-pedal any talk of pulling back from its program, so as not to upset the markets.

However, the chairman took an opposite route, adding the detail of a timeline to last month’s suggestion that the bank could begin winding down purchases. That caused a bit of a stir, leading to a near-4% decline over the following two days in equities and a general decline in asset prices of everything. The odd thing is that everyone may have been partly right.

The FOMC is right because the size of the Fed’s balance sheet has reached a point where the bank needs to give serious thought not only to halting its expansion, but reducing it. The larger it gets, the more unwieldy the eventual exit. It may seem counter-intuitive, but it’s much better for the Fed to stop buying Treasuries in September, for example (cutting its current pace of bond purchases in half) and leave itself some room to come back in later if something goes awry, than the alternative of appearing to have nothing left to spare should problems blossom in Europe (or China, or the US domestic economy).

The markets are also near their all-time highs. ‘Tis better to trim policy accommodation when prices are higher than lower, and it bears repeating a point I’ve made before – stock prices could lose another ten percent without violating the long-term trend in place since March of 2009. Equities have plenty of buffer left. All that has happened price-wise is that the first-half May bulge, made up of equal parts short-covering and infatuation, has been erased. Readers of this column should not be surprised.

The fast-money traders who deserted the market in droves in the hours following Mr. Bernanke’s press conference may also have been right. Yes, it was mostly hedgies and fast-money types bailing on Wednesday and Thursday, and don’t forget that the amplitude of the move on the way up Monday and Tuesday was exaggerated by the same high-frequency trading (HFT) that exaggerated the move down after the Fed’s party.

The reason fast-money traders were probably right is that they were taking out the money that had been bet on the belief in quantitative easing with no end. I suspect that many of them did not personally subscribe to this theory, but much of their trading is done by algorithms that simply read the tape. When the belief script waxes, put more money in, when it wanes take it back out.

The real question for both stocks and bonds is, who is right about the economy? The Fed and perennially bullish mutual fund managers, or the many economists and bond managers like Bill Gross and Jeff Gundlach, who see a slower economy and the likelihood of a rally on the 10-year Treasury bond back to 2%? The bond sell-off has likewise been exaggerated

One possibility that you may wish to keep in mind is that Mr. Bernanke and his fellows could be trying to have it both ways. The Fed did raise its GDP outlook slightly for 2014 and 2015, but it’s possible that they are counting on lower inflation to boost the same nominal GDP to a somewhat higher real GDP. It’s also true that the bank has something of an institutional mandate to be positive about the long-term outlook – it has been predicting a better year-after-next for as long as I can remember and probably back to the days of its founding. As I wrote on Seeking Alpha during the week, culturally speaking the Fed isn’t allowed to predict recessions, only acknowledge them.

If the FOMC’s prediction of 3%-3.6% GDP next year is correct, then mutual fund managers and their ilk are right to be optimistic. Once the market gets used to the idea that growth really can replace easy money in the handoff, it could start to move up again. So are they right? The bank’s forward estimates are higher than those at the IMF, and have been too high for several years. The current data trends that I see don’t point to a revival, and ironically the Leading Indicators reported a downbeat 0.1% the following day.

The Fed’s narrative, one partly shared by other central banks, is that employment and housing will continue on their recent trends – linear extrapolation is about all the Fed seems to trust – and thus pull the rest of the US economy along to a somewhat higher pace of growth. As this healing occurs, Europe somehow magically heals as well, or at least the process of time enables some sort of equilibrium point where the continent can stop declining. That creates a virtuous circle allowing both China and the US to pick up the pace of activity, and finally Europe. Essentially it’s a bet that time heals all wounds.

It might, but the wait could be long. Europe still has major work to do, and has never seemed inclined to do it without a crisis. In addition, while the globe is always at risk of problems breaking out somewhere, the global economy is slowing enough that one of them – Syria, Iran, social unrest in any of a dozen places – could exert a larger braking effect than usual. The Fed says it will be data-driven, and I imagine it would like the markets to follow its example. Perhaps we will.

At the end of the previous week, the Fed had let it be known via the Wall Street Journal that it felt it was being misread by markets. It then leaked another dovish adjustment to the paper the Friday past. There seems to be no shortage of extra communications from the Fed, and yet I wonder if things are any better than the Greenspan days. I suspect that Chairman Ben took all the griping about his predecessor’s infamous opacity too seriously; the Street will always find something to complain about.

Governors should start fanning out next week to begin their usual routine of embellishing the latest statement; Mr. Bullard from St. Louis did not wait, dissenting in writing (rare) that the Fed should not have put forth a schedule. A bold move, though I wonder if in this instance it wasn’t Mr. Bullard showing a bit of naiveté. The market was never going to react well, and HFT exaggerates everything these days.

Political complacency, both here and abroad, has been a problem and is another reason to slow policy accommodation, because only crises can get the modern legislature to do anything but play to its base. Granted that Nouriel Roubini’s outlook tends to the dour, I thought he expressed a good point in his latest paper on “The New Abnormal” when he wrote that recent monetary tools are “Band-Aids applied to avert a near-term slide back into recession rather than a genuine effort to resolve long-term structural problems.” The latter is the responsibility of elected officials, not the Fed.

For what it’s worth, I don’t believe that the recent decline is about to spiral out of control; I think the decisive moment will be in the wake of second-quarter earnings in late July and August, unless social unrest beats us to it. There’s quite a load of data next week – expect more volatility.

The Economic Beat

The FOMC announcement was obviously the week’s market-mover, but there was interest elsewhere. The private-sector purchasing manager survey for China, for example, showed a nine-month low of 48.3, and was partly blamed for Thursday’s sell-off (it wouldn’t have mattered at all if Bernanke had said the right things).

The latest manufacturing surveys from New York and Philadelphia were curious. The New York survey surged unexpectedly to a positive reading of 7.8, versus consensus of about zero. But nearly every underlying category fell, with new orders posting a reading of (-6.7) and shipments falling even more steeply to (-11.8). Employment and backlogs were equally negative.

Over in Philadelphia, the survey likewise posted an unexpected pop to 12.5 versus similar expectations for about zero. At least new orders were consistent, as they too rose with a big jump to 16.6. Unfilled orders and employment continued to contract, however, indicating the possibility that another mild reload is underway (we’ve been overdue for one), rather than any general change in trend.

On the housing side, homebuilder sentiment rose above 50 (neutral) for the first time since 2006. It was followed by a decent report on May housing starts that wasn’t quite as strong as expected, but did maintain the year-on-year growth rate of about 27%-28%. The interesting part of starts was that the strength was all in multi-family housing, with single-family building showing another month of restraint (+0.3%). Homebuilders have been talking about keeping a lid on rebuilding inventory, and it looks as if they are keeping to their word. It may also reflect different conditions in credit markets, as the multi-family market is awash in investment money while the single-family newbuilding market still struggles with tight credit.

Existing home sales in May also rose to a year-on-year rate of +12.9%. That market is likely to cool a bit in terms of volume, as even the realtor’s association chief economist admitted that prices are rising “too fast” due to tight inventory. I suspect something of a mini-stampede as well, set off by fears of price rises and higher mortgage rates. Rates were still lower than May 2012, but the trend may be reversing.

Two items in favor of the Fed’s position came from the Consumer Price Index (CPI) for May and the latest weekly job claims data. The CPI year-on-year increase remains at 1.7%, below the Fed’s target range, while the core rate is a negligible 0.2%. The lack of inflation could be useful (or it could be a prelude to deflation). While the increase in claims last week to 354,000 (seasonally adjusted) doesn’t seem positive, I suspect another lump from California. The year-on-year change in four-week claims has returned to 10% declines for two months running, and while those are based on unadjusted data, it’s still encouraging.

Next week has a heavy calendar of market-sensitive data. Tuesday features a line-up of May durable goods and new-home sales reports, June consumer confidence and April Case-Shiller data on home prices. Will good housing data reassure markets about growth, or frighten them with the increasing prospect of Fed tapering? It’s a bit ridiculous, but the market has been running on emotions for months.

Wednesday has another revision to first-quarter GDP, which may take on additional weight in a nervous market. Thursday has May personal income and spending, and that is a key report on where we are going. Pending home sales follow later that morning, with the influential Chicago PMI (purchasing manager survey) coming out Friday morning.

There are a number of regional Fed reports as well, most of them devoted to manufacturing and it will be interesting to see if they continue the rebound trend exhibited by New York and Philadelphia. Dallas reports Monday, Richmond on Tuesday and Kansas City on Thursday. The Chicago Fed reports its national activity index on Monday, prized by wonks like yours truly.

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