FINANCIAL REVIEW

The Grand Experiment

Sinclair Noe — October 29, 2014

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Financial Review
DOW – 31 = 16,974
SPX – 2 = 1982
NAS – 15 = 4549
10 YR YLD + .04 = 2.32%
OIL + .53 = 81.95
GOLD – 16.20 = 1212.60
SILV – .11 = 17.19

The Federal Reserve wrapped up their 2 day FOMC meeting. There were no surprises. The Fed is ending Quantitative Easing, just as they promised they would. There was a very slight change in their description of the labor market and inflation; saying underutilization in the labor market is gradually diminishing; and regarding inflation, the rate of price changes has slackened recently because of lower energy prices. The Fed kept their phrase “considerable time” to describe how long they will hold off raising interest rates.

Quantitative Easing is Fed-speak for large scale asset purchases, or another way of saying the Fed had been buying US Treasuries and mortgages. At one point they were buying $85 billion a month. Over the past year they’ve scaled back purchases, cutting back about $10 billion after each FOMC meeting. Earlier this month they had scaled back purchases to $15 billion, and now the buying spree is over. Except it isn’t really over.

The Fed has spent about $4.5 trillion and removed a tremendous amount of bonds and mortgages from the market, greatly reducing supply. The basic supply demand equation says that when you reduce supply, prices go up. Sure enough, prices for bonds have gone higher, pushing yields to historically low levels. And even as the Fed has tapered off its purchases, prices have remained high and rates have remained low. There are a couple of reasons for this. First, the Fed is just holding onto their purchases; just because they stopped buying doesn’t mean they are selling bonds back into the market. They will hold those bonds to maturity, and they might even roll over their holdings; meaning when a bond matures, they take that money and buy a comparable bond. The Fed’s bond holdings will naturally shrink as bonds come due; as new debt comes onto the market, the Fed’s portfolio will have less impact. The Fed says it won’t allow the portfolio to start shrinking until after it starts raising the short-term interest rate it controls, the federal funds rate. That’s likely to happen sometime in 2015.

Also, there are fewer new bonds. In case you haven’t noticed, the Federal deficit has been shrinking. This time last year, focus on the federal deficit grew so intense that the government shut down for 17 costly days. The government borrowed 40 cents for every dollar spent in 2008. Now it’s just 14 cents. The budget deficit declined to $486 billion in fiscal year 2014. We have midterm elections in less than a week, and nobody is talking about the budget deficit, but one of the side effects of a shrinking deficit is that the government issues fewer bonds. Again, we go back to the laws of supply and demand.

You may have also noticed that the housing market is vastly different than it was a few years ago. Today, the Census Bureau reported that the home ownership rate fell to 64.4% in the third quarter; that’s the lowest level since 1994, and down almost a full percentage point from a year ago. The steady decline in the homeownership rate is partially the result of tight lending conditions and a historically low share of first-time buyers. That means fewer people are getting mortgages; that means fewer mortgage backed securities.

And the Fed recently announced the conditions for the next bank stress test. The Fed wants to see the banks holding more Treasuries and fewer junk bonds and low-grade, high-yield assets. And banks aren’t the only buyers; foreign investors continue to buy US Treasuries. The ten year note yields 2.32%, compared to the German 10-year bund paying 0.9%. So, in addition to keeping supply tight they’ve also built in demand.

In part due to the strengthening dollar and weakening foreign economies, inflation has failed to pick up despite the Fed’s unprecedented easy monetary policy, and despite improvement in the economy. Imports to the US are cheaper. So if you think of inflation as how much you can buy with a dollar, inflation is going down.

Meanwhile, GDP grew at 4.6% in the second quarter, and it will likely be in the 2.5% range for the full year, not great but growth nonetheless. And one of the areas of growth has come from the oil boom. The Fed still sees inflation as likely to stay near its 2 percent target, despite lower oil and gas prices: “Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.”

As the price of oil has dropped from $3.70 a gallon in late June to right at $3 a gallon, that has kept a lid on inflation. Consider a family that buys 90 gallons a month to fill up two cars. Household savings would total about $60 a month at current prices compared to what a family would have paid early in the summer. That’s $720 over a full year.

But perhaps the biggest reason inflation is not rising is because demand is dead in the water. People were seriously hurt by the market meltdown in 2008; they lost money in the stock market; they lost money in the housing market; they lost jobs; and if they had debt they got a double whammy. Now, they hold onto a dollar until the eagle grins. And demand won’t increase until the job market gets better and incomes start to move higher.

Wages have not been going up. At the FOMC meeting in September the Fed said: “Labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.”

And now the FOMC says: “Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.”

It is a small shift in language, but important. The unemployment rate has dropped to 5.9%; the number of people participating in the labor market is now at a 36 year low; there are still 7.1 million people working part-time for economic reasons; there are still 2.9 million people who have been out of work for 6 months or longer and they are still looking for a job; one in five workers was laid off in the past five years and about 22% of those who lost their jobs still haven’t found another one; and about half the layoff victims who found jobs said the new jobs pay less than the old jobs. There is still slack in the labor market.

What this means is that the Fed should be in no rush to raise interest rates. The labor market still has plenty of room for improvement, inflation is not a problem. The Fed should be able to give plenty of guidance to the markets concerning any changes. The precise timing of interest rate increases should not be a major concern because the Fed has been and will continue to guide to change. And so today, the Fed was understated. They left their options open; they weren’t hawkish, they weren’t dovish. The statement was exactly what was expected. The Fed was not influenced by a rocky October; they were not swayed by weak global markets. There were no surprises.

Still, the prospect of higher rates and the end of QE will almost surely result in a tantrum on Wall Street. The S&P 500 rose 35% during QE1 (Dec. 2008 through March 2010), gained 10% during QE2 (Nov. 2010 through June 2011) and has gained about 30% during QE3 (from Sept. 2012 through this month).

Three months after QE1 ended, the S&P 500 fell 12%. And three months after QE2 concluded, the S&P 500 was down 14%. As for the end of QE3 well, we’ll just have to wait and see. One difference is that now, the economy is supposed to be in better shape. The banks have had the chance to fatten their balance sheets to better weather an adverse scenario. Investors have enjoyed 5-plus years of a bull market on Wall Street. The end of QE3 is an indicator of the Fed’s confidence in the recovery. Plus, the whole QE thing was getting a bit worn out; it didn’t pack the same punch as before.

Of course QE is now in its third iteration. The Fed paused QE twice, only to be forced back into more easing as their outlook proved overly optimistic, and their earlier efforts proved to have been too modest. Studies have shown that quantitative easing has reduced unemployment and pushed down mortgage rates. But Fed officials have had to temper any enthusiasm over those improvements with the recognition that the economy is far from healed, and it remains vulnerable to global and domestic slowdown, as well as any number of exogenous events.

The Fed believed its massive bond purchases would save the mortgage market and the housing market had the potential to support a broader swath of the economy. They could help reduce long-term interest rates, encouraging businesses and consumers to borrow and spend money. Lower rates could also force skittish investors to take new risks. And, most importantly, the boost to the recovery would hopefully translate into new jobs for millions of Americans. But the housing market is sluggish. Consumers continue to cut back on debt. Corporations sit on piles of cash and only deploy debt for stock buybacks; a quick fix for artificially pumping up earnings per share and executive bonuses at the expense of productive output. Investors have been forced to chase yield, although many rejected that risky endeavor and just cut back on lifestyle. And although the jobs picture is improving, the income picture is not.

You could call fiscal policy a failure. Congress has managed to display profound ignorance of economics, mixed with an excess of dysfunction, and what appears at times to be an intentional destructive intent. You can’t call QE a failure. You could call it expensive, and a bad value, and incomplete, and not comprehensive or broad based. Or you could call it a grand experiment. And that experiment is not over yet.