Backstage at the Fed - Q4 Edition

We attempt to survey the Fed every Qt or so, drawing on old contacts (those still with the living) and some of a fresher variety; the purpose is to measure staffer satisfaction with the Chair, alternative policy ideas, the landscape just ahead, etc.  Summarizing our findings today we do for pure relaxation, perfect as Thanksgiving gets underway.

First, there is no question Bernanke is liked by his colleagues; maybe not regarded as the best central banker that ever lived, but, most are fond of him. So are we. He is a fine guy, his candor - a welcome change at that post.

The next consideration is policy agreement. Few staffers we spoke with think present policy will do much good. Most, although they don’t use the phrase, compare it to cheer leading. Most understand that the power-lifting now must be done by Congress, not the central bank. 

To review what is presently in place: The Fed is swapping about $45 bln of short-term Treasuries for longer-term debt. The Fed is in addition buying $40 bln a month in mortgage-backed securities. Finally, when “twist” expires the end of December, it is very likely the FOMC will begin outright purchases of about $45 bln.

Most staffers we talked to admit “twist” amounts to little more than a change in the makeup of the Fed’s portfolio.  Next, most staffers we talked to think it will make little difference to the economy as a whole if the Fed mops up a little mortgage debt. Most feel that Bernanke is making what amounts to fiscal policy in desperation that Washington will not. But too, they figure none of this can hurt.

Beg to differ.

Interventionism is corrosive at a central bank (unless in time of crisis – ’08). We know from the painstaking work of Friedman, Schwartz, Taylor and others that only rule-based central banking delivers prosperity. We saw this in play in the 80’ and early 90’s. A dual mandate is also corrosive because it invites political tinkering, and, it is a redundancy - stable prices create full employment. Planners in central banking will be no more successful than planners in government.

So we have a Fed which is printing a ton of money, the majority of which goes right into “excess reserves” because these pay 0.25%.  Equity types do ok – temporarily - and seniors get busted. That’s about it. (Most staffers figure Bernanke will keep at it, but will switch to an economic goal as a target and eliminate the commitment to a calendar date.)

Next, “twist” has kicked up the rates in the repo market - the fueling place for funding new consumer and corporate loans, and for REIT’s. Thus “twist” provides a hindrance to this activity.

Excavation of faulty logic at the Fed is part of our job, but translation is the other.  This is where a handle on crowd behavior comes in useful. 

Recall that little bit of fun at trading Fed policy, when on Sep/14 we advised that readers (and instructed clients) to sell the US term structure. This of course was to take advantage of the crowd frenzy following the announcement of QEIII; 5-10, then 116, 2-30, 285.  These were taken in Sep/27 at 100 and 254. 

Yet these opportunities have come along all too infrequently; years past, with FI price change in a higher gear tied to Fed intent, they were plentiful.  Nowadays we have to be satisfied with ambushing a straggler or two from time to time.


Robert Craven
 

Keep it Simple

Keep it simple - the “fiscal cliff,” problems of the E-Z, East coast weather – all, already priced in the US fixed income market. The odds were never more than 15% for an off-the-cliff fiscal event. Some compromise will be reached – kick the can. Something will be worked out for Greece; that problem was priced in weeks back. France’s bad luck is a non-event for our mkt. The East coast will recover (but the process will add little to nothing to GDP). These things provide fodder for media types but end there. 

What is not on most radar screens, what observers have yet to come to fully understand is the regulatory cliff just ahead and its impact on CEO attitude, on job creation and, on consumer activity. Better to anticipate the headlines, than react.

Most are aware of some retardants provided by Obamacare – pay the penalty or cut the hours, cost increases in the form of a lower FSA cap of $2500, 1/1/13, etc.  But there is much more. Henry Miller, a physician and molecular biologist and a fellow at Stanford’s Hoover Institution, tells us that, “The administration has already imposed an array of dubious…regulations that will cost consumers tens of billions of dollars. Some of these in the form of hidden tax increases such as user fees for industry such as drugs, biologics, medical devices and food…”  We have already highlighted the effect of the catastrophic 2.3% excise tax on medical devices, a tax not on profit, but income! This will naturally be passed on to the consumer.

Next, Susan Dudley, director of the George Washington University Regulatory Studies Center says that about 35% of new regulations with an impact of $100MM or more per year have yet to be enacted, postponed for the election.

So it’s easy is it not? We have an interventionist administration. CEO’s are there to take to the field which means taking risk, something they are paid to do but not if the rules for the next quarter have yet to be written.

It is important that strategists understand this simple dynamic and its very deleterious impact on risk takers; when this is compounded by the existence of a central bank which combines industrial policy (assistance to select firms and industries) with money printing, no wonder, as the WSJ noted recently, that 40 of the nation’s biggest corporate spenders have announced plans to curtail capital spending in 2013. No wonder these types run for cover. No wonder hiring is going nowhere.  No wonder discretionary spending will wilt for goodness sake.

See your trades accordingly.


Robert Craven

Into the Swamp

We are not to blame Obama for our economic ills just as Marcus Tullius Cicero knew some 2000 years ago not to blame Ceasar. “Do not blame Ceasar,” said Cicero, “blame the people of Rome who have so enthusiastically acclaimed and adored him…blame the people who hail him when he speaks in the Forum of the new, wonderful good society…meaning more money, more ease, more security, more living fatly at the expense of the industrious. Julius was always an ambitious villain, but he is only one man.”


The results of Nov/6 cast a pall over the US economy. East-coast weather and E-Z events merely provide a distraction, cover, camouflage.

We noted earlier that readers were to look for surprising vigor in two sectors – jobs creation and discretionary spending – given an endorsement of free enterprise, Nov 6. That was to be translated to the bottom line Q1 by the simplest of means - the curve, Euro strip, and the selling of US debt to both the UK and E-Z.  

We noted also that clients were to look for something less than expected from these two key sectors given an extenuation of what has been a failed experiment.  That will be the result just ahead, even assuming a resolution to the so-called “fiscal cliff.”  One needs only to glance at headlines such as this one – “Medical Giant Stryker cuts 1170 jobs, citing ObamaCare” - to know that consumer discretionary spending just ahead will wilt. This kind of thing scares the pants off almost everyone. You don’t need a model to figure that out.

Other sectors will not contribute enough at the margin to do much good.  Manufacturing for example will go nowhere quickly as the sluggishness of overall economic activity and final demand, the ending of the inventory rebuilding cycle and worries about the global economic and political outlook will keep a lid on any rebound. With the inventory cycle complete, manufacturing will need to detect a real spurt in consumer durable goods spending before kicking in. That won’t happen.

We have monitored the US economy now for over thirty years; never have we seen such a kick-in-the-gut delivered to those who fire the US engine. Only the malaise delivered by Carter compares. The voter breakdown clearly shows that those receiving some kind of government largesse outnumbered those competing in the marketplace. Until it is mandatory for every high school senior to prove in a written test that he or she understands F.A. Hayek, we will remain in the swamp.


Just ahead: We all know that weather will distort certain key reads so that for example jobs numbers will not be taken at face value, near term. Weaker consumer prints will be similarly dismissed. But most economists will look for a rebound, Q1.  Instead, the clear risk is for something less.

We are no longer are interested in selling in the US (S 10yr) to either the UK or the E-Z; the next opportunity may be in fact to own US debt vs these credits.


Robert Craven
 

And So It Begins

Within 48 hours of the election the following companies have announced layoff plans (we do not yet have all the #’s): Boeing (30% of mgmt staff, def div), US Cellular, Westinghouse, Iberia, Research in Motion, Groupon (80), West Ridge Mines (102), Energizer Holdings (1500), ING, Ericsson, Bristol-Meyers (500), Corning, Boston Scientific, CVPH Medical Center,  Abbott Labs, St Jude, Caterpillar, Hawker Beechcraft (400), Pepsi (4000). 

Last week, Ohio-based auto parts manufacturer Dana Holdings warned employees of potential layoffs just ahead if Obama wins. CEO Roger Wood isolated the burden of “increasing taxes on small business,” and the need to “offset increased costs that are placed on us through Obama’s new laws and regulations.” The mandate will cost Dana, “approximately $24 million over the next six years,” Wood noted.

On Nov/7 a Las Vegas business owner with 114 employees fired 22 as a result of Obama’s re-election. “I explained to them a month ago that if Obama gets in office that the regulations for Obamacare are going to hurt our business and I will make provisions to make sure I have enough money to cover the payroll taxes, the additional health care I will have to do.”

In almost all cases, the layoffs listed above are tied to Obamacare; the rest are industry-specific such as pharmaceutical and coal (both industries penalized by the adm) and Boeing of course tied to likely defense cuts.

Through the period leading up to the election, then with a final installment on Sunday, Nov/4, we were very specific in our advice to clients – given an Obama second term, both consumer discretionary activity and jobs-related activity will wilt. 

Set trades accordingly.


Robert Craven
 

A Glance at the UK

We noted Oct/25 that the UK desk anchor set earlier would remain in place; that is, observers would continue to underestimate real-sector results.  We were mistaken; manufacturing and services PMI prints and industrial production did not cooperate.

Change of plan?  No. Some anchors need to be re-set when they fail.  Others just slip a tad.  We will let this one be.

From late June we have had a plan for trading the UK. Those clients who have adhered to our general guidance have done reasonably well; nothing spectacular, but better than a stick in the eye. Naturally we did not expect absolute vigor or anything of the sort, simply something more than was priced in – all that counts.

Therefore, from that beginning (6/27) we knew the course-of-least resistance for the term structure would be wider because 1) we expected additional Bk of England firing (or the view for such an event), 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.

Sure enough, the spread expanded nicely; it has now come in a tad of course but is nowhere near entry levels.

Yet be aware of a new retardant to world growth - that would be recent US election results. The event of Nov/6 will have a near-immediate impact on both US discretionary appetite, and on US job creation. To the extent these in turn will impact the UK, they will impede any progress just ahead.


Robert Craven

Market Vulnerability

Desk FI strategy into year-end and through Q1 will be tied to the results of Nov/6. 

Given a Republican victory we will look for “surprising” strength in both payroll and consumer-related releases. Given a Democrat victory, we will look for “surprising” weakness in both of these series. 

Strategy can be constructed in any number of ways; for the purpose of this blog we generally confine our sample to the term structure. Notwithstanding the instrument, the idea is to strike at the extremes.

Recall our last illustration. Given the market-crowd frenzy following the announcement of QEIII, readers were told 9/14 to sell this spread (S – L), then 116, 5 – 10yr, 285, 2 – 30 yr.  Those who resort to examination, versus association and sympathy, understood the opportunity. Readers were then instructed to take in this position 9/27 at 100 and 254, a handy little exercise.

The same general approach will apply just ahead, yet based on a vulnerability of a different sort.  For example, observers will grossly under-estimate CEO enthusiasm tied to a Republican victory; the same observers will completely miss the giant sucking sound as potential job creators and consumers withdraw, given the reality of 4 more years of what has proved to be a failed experiment.

So the concern for the bottom line is key. But we are also concerned for our Country. How She got this far is a mystery given the lack of scholarship of so many of those who enter the voting booth. We are hopeful that enough have come to understand that our prosperity (and by linkage, that of the free world) does not depend on an expansion of the public sector but on the unleashing of private activity through the elimination of gov’t and central-bank interventionism and the birth of a reformed tax system; and, all of this anchored by the rule-of-law.


Robert Craven