FINANCIAL REVIEW

Fed Patiently Makes Hawkish Sounds

Sinclair Noe — January 28, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 195 = 17,191
SPX – 27 = 2002
NAS – 43 = 4637
10 YR YLD – .10 = 1.72%
OIL – 1.19 = 44.26
GOLD – 8.80 = 1284.30
SILV – .07 = 18.06

Microsoft’s stock logged its biggest one-day dollar decline in nearly 15 years on Tuesday, after the company posted disappointing earnings Monday afternoon. Shares of Microsoft closed down 9.2%, or $4.35, to $42.66 on Tuesday, wiping out $34.7 billion in stock-market value. The Dow Industrials dropped 291 points Tuesday.

Then after the close of trade yesterday, Apple posted the largest quarterly net income of any public company in history; $18 billion. That provided an early boost to the markets today; at least until the FOMC statement.

The Dow Industrials are down from record highs, but not too bad. Since hitting an intraday high of 18,103 on December 28th, the Dow has been choppy through January; on three occasions dropping down to the 17,200 range but not dropping under (17,262 on January 6th, 17,243 on January 16th, and 17,288 yesterday). These three lows formed a floor, or a level of support for the Dow. Today, the Dow closed at 17,191; we broke support. And the next level of support is 17,067 from mid-December and the big round number of 17,000. If we break the 17,000 support, the next level is 15,855 from mid-October.

The Federal Reserve continues to try to make the case for patience; which is to say, a low interest rate environment, at least for now. The FOMC wrapped up their two day policy meeting today and repeated it would be “patient” in deciding when to raise benchmark borrowing costs from zero. They were a little more upbeat about the economic outlook, saying “Economic activity has been expanding at a solid pace,” a slight shift in words from their earlier assessment of a “moderate pace” of growth.

The FOMC issued a statement but there was no news conference today. The statement said: “Labor market conditions have improved further, with strong job gains and a lower unemployment rate,” and “Recent declines in energy prices have boosted household purchasing power.” The Fed believes the economy will move to 2% inflation “as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.”

Low oil prices are a key part of the equation. If prices rebound quickly, and climb back to $100 a barrel, then the Fed will probably respond with higher rates. But the drop in oil has been so strong it might not be a “V” recovery. There are benefits to the economy from lower oil prices; it stirs the animal spirits. Also, it tightens the screws on oil producers such as Russia and Iran and Venezuela, making them more receptive to negotiations.

It was one of the shortest statements in a couple of years, likely designed to give the impression that everything is normal, everything is on pace for the long promised rate increase. No reason for delay but no rush either. The overall tone of the statement was bit more hawkish and that sent stocks and oil lower, but pushed bond prices and the dollar higher.

There are some people who believe the dollar will crash, the economy will implode, and zombies will roam through the streets; even though they have no facts to support their theories. The problem is that the Fed is still saying they will eventually try to raise interest rates – despite speculation of QE4.

Those looking for the Fed to save the day with QE4 are probably looking in the wrong place. The US economy is the cleanest shirt in the dirty clothes hamper, and it just doesn’t make sense for the Fed to jump back into QE, not now; they are well aware that such a move would smack of desperation, have political implications, and likely produce less than satisfying results.

Plus, you may have noticed the economic data doesn’t support such a move. The unemployment rate is down, and even though wages have been stagnant for the long-term, they aren’t collapsing. (Note: I’m not saying wages will jump; just that there doesn’t seem to be a big chance of a large decline). Most of the economic data is pretty decent: third quarter GDP was very solid, and first quarter GDP should be decent (we’ll find out later this week). Consumer confidence is high, even if that isn’t translating to durable goods orders.

Perhaps the biggest long-term market risk is the amount of debt companies have piled up in the low interest rate environment that the Fed has created. Companies have used low interest debt to engineer buybacks and acquisitions, and sometimes just to keep dollars offshore and away from the IRS. And it isn’t just companies but the government as well; debt service on $18 trillion in debt would get expensive fast. If the Fed raises rates, they run the risk of having to reverse course and undo rate hikes if it goes bad and the economy comes to a screeching halt. There is no fundamental reason right now to raise rates and there is really no reason for the Fed to try to get in front of the recovery; it smells a little too much like 1937. So, for now the Fed can jawbone; that is, to issue hawkish statements without actually doing anything hawkish; and then sit back and wait, patiently.

No matter how it plays out, the Fed would have to communicate, they would have to lay out a full-fledged campaign or a full-fledged crisis to get to justification for QE4.

This is not about American fears, it is more about global weakness. It is about how the world transitions away from Fed-driven liquidity and passes the baton to the rest of the world. If you haven’t noticed, the hand-off has been taking place. The ECB introduced QE last week, which is probably too little, too late; the most likely result being the Eurozone will need another round of QE. Japan has been in QE mode for quite some time; actually QQE – the Bank of Japan’s promise to double the monetary base, which will likely be extended in April. China’s economy only grew at 7.4% in 2014, the slowest rate of growth in 24 years, and they are now targeting 7% growth for 2015, and to achieve that they will inject liquidity.

This is all about what is happening around the world, not America. The concern is not just that weak global growth will dampen US exports, or that a strong dollar with further hurt the export sector of the economy and cut into multinational profits. The strengthening of the dollar can lead to imported deflation, touching off another down leg in the US with the rest of the world sneezing, the US catches cold.

While it is possible that Yellen could turn more dovish, any such move would probably not entail QE4 (unless there is a crisis). If domestic growth is threatened by global factors, look for the Fed to use unconventional tools. And if you think QE and interest rate policy are the only tools in the toolbox, think again. One easy move would be to stop paying interest on excess reserves held by banks at the Fed. Stopping those payments could force the banks to pull their excess reserves and find more profitable uses for the funds, like making more loans; at least in theory. In practice this has been an ineffective tool, but it is the opposite of tightening.

The Fed could also take action to devalue the dollar, slowly and incrementally of course, to revive exports. The Fed could relax credit restrictions. The Fed could buy different debt instruments, tied directly to infrastructure. Or Fed Chairwoman Yellen can use the bully pulpit to push for fiscal stimulus.

For now, the focus will be on how the liquidity baton is passed from the Fed to the other central banks. And the “patience” of the Fed is just an opportunity to assess the progress of more easing from the rest of the world.

It is earnings season and here are a few selected reports:
After the closing bell, Facebook reported net income rose to $701 million in the fourth quarter, compared with $523 million a year ago. Profit excluding some items was 54 cents a share, topping estimates. Revenue grew 49% to $3.8 billion, also topping estimates. Facebook was flat to slightly lower in after-hours trading.

AT&T posted fourth-quarter earnings of $0.55 cents per share excluding items, up from $0.53 cents a share in the year-earlier period. AT&T also reported robust subscriber growth, announcing 1.9M net subscriber adds.

Boeing climbed 3.1 percent after posting profit that beat analysts’ estimates and predicted that it would make good in 2015 in converting a record jetliner-order backlog into cash.

About 77 percent of the S&P 500 companies that have posted earnings this season have beaten analyst estimates, while 55 percent have topped sales projections – this according to data from Bloomberg.

FXCM Inc., the currency brokerage that almost collapsed this month as the Swiss franc surged, will seek repayment from institutional and high-net-worth customers whose accounts went negative amid the volatility. Those investors account for about 60 percent of the brokerage’s losses. However, New York-based FXCM said today in a statement that traders who made smaller bets, about 90 percent of clients with negative balances, will have their losses forgiven.

Royal Dutch Shell has signed an $11 billion deal with Iraq to construct a petrochemicals plant in its southern oil hub of Basra, after signing a memorandum of understanding with its Industry Ministry for the project in 2012. Shell’s facility, which is expected to come on line within five to six years, would make Iraq the largest petrochemical producer in the Middle East.