Backstage at the Fed

Let us take just a moment to distill the current policy view, backstage at the Fed.  As we do so, it’s best to tune out the siren song of complexity.

Very, very few staffers (various districts) seriously think the present program will make much difference for the economy as a whole. Those Fed officials who claim otherwise are performing the combined feat of whistling in the dark in their cheer-leading outfit, twirling their pom poms.

There is no “party line” any longer, as in the Greenspan days; we have wayward children to be sure. But, it is still Bernanke’s view that is key. Bernanke is greatly concerned with lack of progress in Washington and so is acting as a surrogate. This is what we meant in an earlier sketch - the Fed is attempting to make fiscal policy.

Many of us understand that it is in the best interest of our Country if Bernanke were to sit on its hands.  But Bernanke, although highly uncertain his programs will amount to much is very keen to continue with his cheer leading. He figures it’s about all he’s got.


Robert Craven
 

US Interest Rates - near term

We want to take in that last recommended position - US term structure. Exploiting the frenzy tied to the announcement of QEIII, we advised selling (S-B) this spread near the close, Sep/14, 2-30, then 285 or so, 5-10, 116 or so.  Last, 254 /100.

This was a satisfactory little exercise; now look for an exit; certainly do not take this or something similar into Sep NFP, Oct/5.


Robert Craven

A Failed EU? Does a One-Legged Goose Swim in a Circle?

An ECB, an EFSF, all the rest are just fine; they keep the elites busy. But they are a sideline compared to the reality of the minute-to-minute culture of an everyday people.

For example, as a family friend reported after a summer trip to the E-Z, “Germans pick up trash; in Athens, Greeks toss it. Germans do not honk. In Spain the pedestrian is a target; in Switzerland he is considered perhaps your father or grandmother. A bathroom in Germany is where someone else uses it after you; in Greece … it is where you pass on the distaste of using the facility to the sucker who follows you.”

I remember when I was there last time. Take traffic courtesy for example, which tells a lot about a culture. If a fender-bender, in northern Europe, addresses and information are exchanged; south of Milan, shouts and empty threats of mayhem follow.

Our friend continued: “When I check out of a German hotel, I know the bill reflects what I bought or used; when I check out of a Greek hotel, I dread all the nonexistent charges to appear, and a '50/50 split the difference' settlement to be offered. Germans like to talk in the abstract and theoretical; with Greeks it is always ‘egô’ in the therapeutic mode. I rent a car in Athens and expect charges for ‘dents’ to appear; in Germany, there are such charges only if there are actual dents.”

It all adds up; any fool knows that these two regions won’t make it locked in a financial marriage. We have a Germany for example that creates vast wealth and we have a Greece for example, whose mode of operation is nothing but a big con job – landing as much of that vast wealth that it did not create, as it can.

Culture is everything.  Thus, there are only two futures for the EU – sudden death, or the death-of-a-thousand  cuts. The problem with the death-of-a-thousand cuts route is that it risks anarchy – Metaxas of Greece comes to mind for example; or the equivalent of a Pattakos, in Spain, and right now. Readers will understand.  This is a very great and very present danger.


Robert Craven

Strategy Update

Let’s take just a moment to review that strategy set recently.  For the purposes of this blog we keep it rather simple and of late have used the term structure, both for the UK and US, to illustrate our view. Of course when one has price delivery in hand for this spread, one has a leg up any number of related strategies.

UK – Readers were to look for the opportunity to own (L-S) this spread from late June (270); under no circumstances look to sell it. The spread expanded nicely, then came back in mid-July to the beginning level, at which time we advised for those not long to get that way. Last, 292, back in a tad from 296, Sep/14.

By all means remain long this spread. We were originally motivated when it was clear economists had under-shot economic reality ahead for the UK; nothing strong naturally, just a miss.  And that is what delivered the welcomed priced change. The expectation for additional BkofE firing ahead had not hurt either. Naturally the E-Z and Iran remain wild cards; still, the odds favor our view.

US – Readers were told to sell (S-L) this spread on Sep/14 following the announcement of QEIII, 2-30 then 285, 5-10, 116.  Last, 267, 107.  Unlike its UK counterpart we will not want to stick with this strategy, but take it in fairly soon. Its purpose was simply to convert mkt-crowd fawning on the Fed, to the bottom line.



Robert Craven

The US Economy - Off to the Races, Maybe

Let us look to the US for a moment; after all, we own the key to a better economic world.

Paul Volker, when addressing a conference at Gleneagles in Scotland last week said that, “We can no longer look to China to rescue the world. The Chinese economy has slowed 50pc since its peak and is no longer able to support international growth. Europe is in or near recession, including the UK. So don’t look to the UK, to China, Brazil or India — the US is the only country that can create the type of economic hope and market leadership the world needs. We have a weaker platform than we used to but it is still the most important platform in the world.”

Most of us knew that but it’s nice to hear it from this gentleman, the finest central banker of our generation, a Fed chairman who arrived by the way of merit, not by the way of political promiscuousness. Volker also noted at that conference that re QEIII, “…it will fail to fix the problem. There is so much liquidity in the market that adding more is not going to change the economy.” Correct.

Now, many observers have the US heading for a stall; some, even worse, 2013. Some of this is of course tagged to the “fiscal cliff,” some to a flagging world economy. They will be right, unless…

First, a brief look at key US sectors as they exist at this writing - our version of “around the US in 60 seconds.”

Trend job creation is about 150M per month, consistent with maybe 1.5% - 2% growth. / Both personal and disposable income rose modestly, last look, reflecting the so-so gains in jobs, a steady workweek and sluggish hourly earnings. / Inflation pressures at the consumer level jumped in Aug and are now 1.7% above their year ago level; they have been slowly retreating from Sep/11’s 3.9%; “core” prices are 1.9% above their year ago level. No one seems worried. / Real consumer spending is up moderately but on a trend basis (year-over-year) has slowed over the past 1-1/2 years. / US manufacturing is slowing less than elsewhere in the world but we saw that in Aug production finally followed orders lower. / Nondefense capital goods shipments, proxies for capital spending, are modestly above their Q2 levels, suggesting that capital spending should accelerate slightly in Q3. / The trade picture has changed little, with both exports and imports retreating slightly. / Housing has entered a recovery phase but from a very depressed level. For example, new home sales are now 25.3% above their year ago level and have been on a gentle rising trend over the past year. Nevertheless, they are still a stunning 73.2% BELOW their July 2005 peak.

Next, we want to know where if anywhere there may be a major surprise just ahead vs present Street view; that is, vs that which is priced in the FI market. There is little potential for surprise, + or -, for any sector, our view. If it does exist, it will reside with consumption, where the risk is for something just a tad stronger than expected into year end.

We all understand that jobs creation is the key to our economic health past year end and by linkage, to that of most of the free world. And real jobs creation won’t happen until the playing field is leveled and the burden lifted from employers and consumers and until the rules and penalties no longer change every Qt. Many left-leaning economists and politicians are in denial regarding this matter but as Irwin Stelzer noted recently in the Weekly Standard, one of their own - Lyndon Johnson - was not similarly confused. Johnson proposed to Congress that it get the economy moving by 1) cutting spending and 2) lowering taxes. As Stelzer reports, “Cut spending and taxes right now, he urged, to eliminate uncertainty. This left-leaning president delivered a State of the Union Address that argued, ‘The most damaging and devastating thing you do to any businessman in America is to keep him in doubt and to keep him guessing on what our tax policy is.’ Add guessing as to health care costs and from many businessmen’s point of view you have a recipe for inaction, for not expanding staff. Tenured academic economists might think businessmen don’t need certainty, but then they are not the best judges of what makes risk takers run.”

So there is hope if we have the leadership (as they have had in Canada) to articulate this truth to the masses, and get that done before November; if that is accomplished, we are off to the races.


Robert Craven

The Fed as a Side Show - Part II

The Fed’s cheer leading is welcomed by a few, equity types for example but most serious observers understand it is simply noise at the sidelines.

However, not everyone who reads this blog has spent any time on Wall Street; some may have a real job in fact – say an Army pilot or a cinematographer - yet are curious nevertheless. This post is for them.

What does the Fed do exactly when it comes to executing monetary policy? For this, don’t think of reality on the farm; don’t think of the household budget; don’t get confused by inserting reality into the equation at all; no, instead, simply fantasize for just a bit. The Fed can buy whatever it wants - a herd of cattle in Wyoming maybe.  Usually it sticks to gov’t or near-gov’t securities because these things are more liquid. To pay for these things, that is, to inject $ into the financial system the Fed simply credits banks with electronic deposits – called reserve balances. And the Fed gets the money to do that from – guess where?  The thin air.

When it does this the Fed expands what is known as the money base – currency, coin and bank reserves. In the past, with all else equal (which is exactly what it was in the past) this meant something.  Now it means almost nothing.

So lately the Fed has been very busy doing this thing which amounts to almost nothing. And it amounts to almost nothing for the simple reason that banks don’t do much with the money.  For example, from Aug/08 until Aug/12 the money base has gone from $908 bln to $2.64 trl. Whoa now! Why aren’t we off and running? Because 85% percent of the Fed's printing press expansion since August 2008 is sitting idle in the nation's banks as excess reserves. Why is that? Because also since ’08 the Fed decided to pay banks a bit of interest on those reserves they weren’t required to hold - the excess reserves - of ¼ of 1% to be precise.

So banks can get short-term deposits at near zero, then turn around and re-invest with no risk at all at ¼ of 1% and then pocket the difference. Think this is peanuts? Not on the kind of money these guys have. In 2011 the Fed paid the banks $3.764 bln on their excess reserves. That’s a lot of burgers.

So of course the banks aren’t about to get out and kick up the dust. There are unknowns and bankers don’t like unknowns, so why bother.  And after all, it would be a tad unseemly to have to come back to that same depositor/taxpayer once again and ask once again for a bailout, if the banks screw up. They’re gun shy, figuring it’s better to lay low than run the risk of being lynched.

Thus, we have a massive expansion of the monetary base and nothing to show for it. This provides fuel to Bernanke’s critics, and, to authors of legislation which would do away with this perk and in fact do away with almost all discretion the Fed now owns. If some have their way, they will also do away with Bernanke.

But back to Fed policy. Now we have a QEIII, remember? – it was just announced with great fanfare. What does QEIII mean? It means the Fed will pump about $85 bln per month into the economy; Oops, sorry, into the banks until the end of the year. Where do you think most of that $255bln will go? Maybe the bank who turned you down for that loan, that loan your established business needs to weather this economy, that same bank which would have jumped at the chance a while back will now jump at it again, drowning as it is in a sea of liquidity provided by QEIII? Nope. Most of it will stay right in bank reserves, earning that reliable ¼ of 1% and without lifting a finger. You’re on your own (but thanks for the bailout).


Robert Craven
 

A Tale of Two Credits

In judging near-to-intermediate term FI price change one must have a view of economic reality ahead but key is to have a view of the market crowd’s notion of reality ahead and understand the FLAW that exists therein, if any. Thus equipped and assuming one’s insight is correct one can do well as the herd reverses direction, stampeding back from where it came. It is only key to get the timing right so as not to be converted to crow bait.

Recent developments in the UK and the US illustrate this point quite nicely.

We advised late June that traders look for an expansion in the UK term structure, that course-of-least resistance for this spread would remain wider into year end and under no circumstances were traders to look to get short (S-L) this spread. (That advice has performed fairly well, 2-30 out from 270 to 297 or so, 9/14, now back in a tad.) Why?  Because of the key FLAW to consensus for this credit; because economists, caught up in the dash for security, badly underestimated economic activity ahead, and, we knew it. Once we had that in hand we had captured price change ahead. Thus, UK Industrial Production, Exports and Employment have blown through consensus. Not strong naturally, simply stronger than most models predicted. Of course we do not want to be accused of cherry picking; a few reads have come in south of consensus; but on the whole, observers were taken in. 

For the US we did not see opportunity in real-sector activity ahead vs street consensus as we did in the UK; that is, we did not think St consensus was far off.  But the opportunity for this credit hinged on crowd behavior and Fed policy. We and our readers have understood that behind the scenes most policy makers understand they can’t do much, that their role has been reduced to that of cheer leading.  But Bernanke and others figure it can’t hurt, and nothing wrong nowadays with making a little fiscal policy when you’ve got nothing much else to do.

Thus, the moment so-called QE3 was announced and the term structure blew out – opportunity knocked, and loudly.  We recommended on Sep/14 that traders sell (S-L) this spread that moment, 2-30 then 285 or so, 5-10, 116; last, 268, 107. As we noted then, real sector developments would not support the crowd’s mad dash, “…the US economy just ahead does not justify the much weaker FI prices logged last two days, even given the Fed move. This will dawn on the market crowd in short order.” 

It just has, with a little help from the E-Z and China.

In both cases we have used the spread that eclipses most other trading activity – the term structure. Very simple, even boring but with that in hand, one can do wonders for the bottom line, through the galaxy of other instruments available.

Finally, this illustration brings us back to basic rules of behavior in trading in this arena. Avoid complexity like the plague. Make way for the crowd's rush, and then strike as the same are about to go off the cliff. Economists and investors – shouting out, holding hands together in the dark.


Robert Craven

Trading the Fed

Now that the dust has settled, let us consider the most realistic trading approach over the near term.

The US term structure blew out 20 bps or so, 2 – 30 (mostly directional) and 12 bps, 5 – 10,  as a result of the Fed announcement.  This presents opportunity. Traders are to look to sell this spread at present levels, not to join the crowd and look to own it (we will want to do that a bit later).

Background: We all know that the Fed committed to a program of purchases of a specific item for one Qt. We also know they left this commitment open ended; they can close at any time, or continue indefinitely, expand or contract. Fine.

Fiscal policy making at the Fed is linked to the absence of responsible fiscal policy making in Washington. Those who have reviewed our recent sketches understand what it will take to provide a real spark to US employment. We wait for that.

But to return to our markets; the US economy just ahead does not justify the much weaker FI prices logged last two days, even given the Fed move. This will dawn on the market crowd in short order.

The trend growth in job creation is about 150M /month, consistent with a growth rate of maybe 1.5%.

Manufacturing activity was off in Aug for the third straight month, the first back-to-back declines in 3 years. It is likely that the recent softness in manufacturing activity and capital spending will continue for at least a few more months.

Although total and core retail activity took a spurt in August, much of the gain was due to the pumps. On a trend year-over-year basis, sales activity has been slowing for the past year.

We also learned today that industrial activity dropped in August, and it was not all Isaac. On a year-over-year basis output has been growing moderately. Those who passed Econ 1-A understand that we will need a spark in consumer durable spending – the best kind of final demand – to strengthen this activity because the inventory cycle is complete. Nothing else will. That won’t happen without a spurt in employment, and hours, and earnings.

Bernanke’s buying of a few mortgages is merely a side show.


Robert Craven

Fed Announcement

There will be little substantive accomplished for the US economy through the Fed’s latest program.

There is a spark for equity types (the 20% who own 93% of equities) and a bit of a boost for mortgage types, but only a bit. Lower, longer rates make hardly any difference. And we are awash in liquidity.

Bernanke is a fine, fair and honest guy; he is a stranger to deceit. Thus we saw his appointment as a welcome change. He is however, as is true with most of his colleagues (Fisher and a few others excepted), out of his league in understanding the auction markets. These markets, like any crowd, demand a god; only a lightning bolt from time to time gets their attention. Bernanke’s Kumbaya-around-the-campfire, soft and cuddly approach does not allow for that. And so he is in a fix, the very fix we predicted in earlier posts.

And this is not lost of most policy makers.  Behind closed doors they know there is little they can do, except favor a few pockets of activity, and, further penalize seniors.

Most policy makers know it is up to Congress but they aren’t sure that Congress will do much.  That is why the Fed itself is trying to make fiscal policy of the stealth variety.

Most of us who have observed the Fed for years know what they should do – sit on their hands (and stop the foolishness of paying interest on reserves).

We have plenty of evidence, thanks to Friedman, Schwartz and others that rule-based monetary policy works and random interventionism does not.  Naturally the Fed is there for another 2008 if need be.  But aside from crisis, a general trend to planning at the Fed is bound to fail. No one can do it; it is beyond any single individual’s competence, either in central banking or government.

The prosperous 80’s and 90’s were birthed by a steady-as-you-go monetary policy (they were also birthed by the reduction of gov’t interventionism and an end to suffocating regulations).  We may return to that next year, but now what? That is, how do we translate today’s announcement to the bottom line?  We will take that up in tomorrow’s sketch.


Robert Craven

 

A Plan for the UK

From late June we have had a plan for trading the UK. Those readers who have adhered to this general guidance have done reasonably well, bottom line; nothing spectacular, but better than a stick in the eye.

Key of course is that under no circumstances were traders to look to sell (S-L) the term structure, only for the opportunity to own it. Because 1) we expected additional Bk of England firing, because 2) we expected further flight to sanctuary (E-Z) and because 3) we knew that most models had excessive weakness built in, this seemed an opportunity (and there haven’t been many of those around lately).

Thus, traders were to own this spread at or near 270 (2-30) on June/27. We made it clear then that this was not a directional strategy, then 0.29 – 2.99%.  The spread expanded nicely into early July (285), then fell back to 270 mid July.  Again, readers were instructed to get long if not already long. That has worked satisfactorily, last 297, or .12 – 3.09%, this writing. 

We were of course gifted today by both the July PPI and Industrial Output prints. The spread may come in a tad from today’s spurt, considering something less than expected from the US NFP read. 

Realize some profits at his juncture but maintain a balance.

Naturally there are many ways to put our insight to use, not simply the ratio spread. But key is to be cognizant of this overriding reality into year end.

Keep it simple.

Robert Craven 

The Federal Reserve - A Side Show

After a long summer vacation we return to the keyboard. OK, we hear the moans out there!  Come on folks, buckle up!

We have known for some time that Bernanke personally favors further accommodation; that was explained in an earlier sketch (Aug/1 – US – A Primer).  From his testimony in Yellowstone it is clear that we were right. Yet aside from harming seniors even further, there is little he can accomplish.

Key to understanding economic reality ahead for the United States – something our readers must be intent on doing or they are reading the wrong blog - is to understand political reality ahead, not central banking. There is no need for verbal gymnastics, no need for complexity; it is simple – a Republican victory in November will cheer large potential employers and small businesses alike.

We are not interested in taking sides; we are only interested in being right, in the bottom line.  Thus, any trading operation keen on anticipating US real-sector activity is best advised to take near-term opinion polls quite seriously.

A reading of our last piece – An American Renaissance – provides background.  A failed US experiment has simply placed the US job machine on hold; a new employee represents a liability, a time bomb. Unburdened of the slew of regulations and likelihood of even more, and of the constraints of higher taxes, employers will come alive. Abolish flagrant government interventionism; abolish gimmick-based central bank policy and we will really take off. We know this to be true; there is precedence here, unseen only by the willfully blind.

Certainly the world economy is less-than-buoyant; certainly the US economy is hitting on 5 or 6 of 8. And there are major unknowns (Iran, E-Z, other), as always. But what is not acknowledged at this writing, that dynamic which has not been captured by even the most optimistic models is the stirring of American enterprise which will be unleashed by the return to Founding values. 

Economic planning always and everywhere ends in failure. This has been true past decades, plain as day for those who cared to look. But we move 3 ahead and then 2 back because there are always just enough of those who excel in noise making yet lack in scholarship to cause the rest of us to sit idly by as these types (hopefully) learn their lesson. This time, there may be just enough who did.


Robert Craven