Between a Rock and a Hard Place

The S&P500 moved up again this week, recording a 2.3% gain.  Interestingly, the volatility index (VIX) closed higher as well, up 2.4% for the week.  What’s interesting is that the VIX is usually inversely correlated with the S&P500 movement.

What’s also interesting is that the S&P500 is now valued at 34 times 2009 as-reported earnings (not operating earnings) estimated top-down (not bottom up) by Standard & Poor’s.   Even on an operating earnings basis, the P/E ratio (using top-down 2009 estimates) is now 22.  Cheap? Hardly.  Fairly valued?  Possibly–but only if the market is correct in anticipating a massive rebound in earnings (as-reported and operating) for 2010 and beyond.

The economic data last week was not showing many first derivative improvements.  Yes, the economy seems like it’s shrinking more slowly (as compared to January 2009), but getting less bad clearly does not mean it’s growing. 

Personal spending rose slightly (0.1%), but the savings rate spiked to 5.7%–great for the long-term, but in the near-term, any increase in savings means lower consumption, which lowers GDP.  Auto sales for May were dismal–again.  ISM services fell in May; they were expected to rise.  Initial claims stayed elevated at 621,000; and continuing claims remained near 7 million.  The average workweek fell to a record low of 33.1 hours; this is important because before businesses rehire folks, they ask their existing employees to work longer hours.  Instead, these hours are still falling.  Non-farm payrolls fell in May by 345,000; but when the 220,000 jobs magically created by the Bureau of Labor Statistics’ birth/death model are factored in, the actual job loss was over half a million.  The unemployment rate jumped to 9.4%, far higher than consensus estimates and the highest rate since 1983.  Also, consumer credit fell by $16 billion in April and a revised (and record) $17 billion in March.  Consumer credit is dropping at a 7.4% annual rate–again important because the consumer makes up almost 70% of GDP.

Last week, the Fed chairman Ben Bernanke, warned Congress that the U.S. government must get its fiscal house in order.  He pointed the finger at Congress and the Treasury and stated that the U.S. budget cannot run multi-trillion dollar deficits indefinitely.  The global capital markets will not tolerate excessive deficit spending and borrowing.

Meanwhile, German Chancellor Angela Merkel pointed the finger at the Fed and scolded Bernanke for going too far in expanding  the Fed’s balance sheet, especially with its program of monetizing Treasury and agency debt.  She contended that overly loose monetary policy will lay the groundwork for another financial crisis.

Ominously, over the last several weeks, the prices of U.S. Treasury and agency debt (as well as the dollar as measured against a basket of currencies) have been collapsing. In the fall of 2008, the 10 year note yielded only 2 percent.  As recently as March 2009, it yielded 2.5%. Last week, its yield soared to almost 4%.

What’s the problem?  The Fed has stated publicly that it wants to drive down government and agency (primarily housing related) debt yields to lower the cost of financing massive  public and household debt loads.  To do so, it has effectively printed money to buy this debt–initially driving the price up and yield down.  But it hasn’t worked.  Yields have jumped, sending the 30 year mortgage rate (for example) up from 4.5% to 5.5%. 

If the Fed does not step up its purchases of this debt, demand may fall further causing yields to go even higher.  BUT, if the Fed does continue and increase its buying of this debt, then the credit markets may reasonably worry that the Fed, by printing too many dollars, would debase the dollar that would repay all the debt held by other investors; this will give these investors a reason to sell (or at least buy less of) this debt, also causing yields to go up.

In a nutshell, the Fed is losing control of U.S. interest rates.  Not only could the resultant higher rates create headwinds for the economic recovery, but the failure of the global credit markets to keep lending to the U.S. at low rates, could lead to a currency (dollar) crisis and shove the economy over the edge of a cliff, for good.

The Fed is truly between a rock and a hard place.

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