Is the Fed Losing Control?

March 27, 2010

Ever so slightly, the S&P crept up another 0.58% last week on declining volume.  The VIX (or fear) index also contradicted the price rise; it jumped almost 5% last week.

The economic data were mostly weak, certainly not the stuff typical V-shaped recoveries–more than two years after the recession began–are made of.  Existing home sales came in at the projected level, which meant a decline from the prior month.  New home sales were projected to rise; instead they fell.  But they fell to the lowest level EVER recorded in this series, fully 13% below the same month in 2009.  Economic recoveries typically do not happen without strong new home production and sales.  Durable goods orders were weaker than expected.  Jobless claims, although lower, are remaining far above the sub-400,000 level usually associated with job creation.  GDP for Q409 was revised downward, when it was expected to remain unchanged.  This means that virtually all of the so-called growth, in the second half of 2009, was the direct result of the government’s stimulus programs.

Technically, the S&P is still very oversold, with all sorts of price and volume indicators diverging (ie. they’re pointing downward).

One of the biggest stories of the week had very little to do with the stock market or corporations in general.  The shocker had to do with the US Treasury, which auctioned off two, five and seven-year notes.  These auctions almost failed.

In fact, were it not for some mystery buyer, the auctions would have failed.  Although it’s difficult to prove (the Fed is fighting off legislative and judicial efforts to open its books), the mystery buyer is probably the Fed.

But what’s the problem if the Fed mops up all the unsold Treasury paper?  Simply put, the Fed failed to accomplish its critical mission–suppressing interest rates.  It’s not enough to buy up all the unwanted debt; the cost of the debt must be kept low. 

Instead, the two through 30 year rates ballooned, to their highest level in eight months.  But they didn’t rise for the good reasons, reasons associated with a booming economy.  They rose for ominous reasons:  widening deficits and a soaring total debt load suggest that the bond market is worried about the US drowning in sovereign debt. 

In fact, things got so bad last week that some two-year corporate bonds yielded less than two-year Treasuries.  Investors were saying that buying this investment grade corporate debt was LESS risky than lending money to the US Treasury.

And the Fed’s inability to keep rates low means that the total funding costs of the massive US debt could spiral out of control.  If rates keep climbing, the government could be forced to pay more for interest expenses, which would in turn push borrowing even higher.

That’s why the Fed must keep this genie in the bottle.  For if it escapes–and it’s already poking its head out now–the implications for our government’s finances could be catastrophic.

What Can Go Wrong

March 20, 2010

The S&P500 crept up another 0.9% last week, on declining volume.  The index is at extremely overbought levels, based on several technical indicators.  On a short-term basis, anyone who buys at this moment, is almost certainly buying at relatively high prices.

The economic data were mixed.  The Empire State Manufacturing survey was slightly stronger than expected, although it dropped on a month-to-month basis.  Both housing starts and permits fell, also on a monthly basis.  Producer prices and consumer prices were both benign, suggesting that inflation in goods and services (as opposed to asset prices) is not in imminent danger of accelerating.  Initial jobless claims were slightly worse than expected, as were leading indicators.  The Philly Fed came in a bit above the consensus forecast.

Now that the Fed has succeeded in reflating many asset classes in the US (and indirectly, around the world), what are some of the pitfalls that could trigger prices to fall suddenly and unexpectedly?

First let’s remember that NOTHING has been fixed with respect to the root problems–the total indebtedness of the US is still at record highs (375% of GDP) and the trillions of dollars in toxic assets (related mostly to residential and commercial real estate) and the derivatives attached to them have not been removed.

Everyone is pretending that the problem lurking beneath the financial landscape  will somehow magically go away.  Something will surely turn up, right?

So what can go wrong, especially in the short to medium term?  What could cause the financial monster to rear his ugly head again?

This is only a partial list of possible triggers:

1. A systemically important country could suffer a debt crisis.  Greece is the most visible.  But the list of other candidates is shockingly long–they include Spain, Italy, Ireland, Portugal, the UK, and Japan.

2. A currency crisis (most likely linked to a debt crisis) in many of the same nations and regions: the euro, the pound, the yen, etc.

3. A threatened bankruptcy in a US state–California, Illinois, New York and several others are near the brink.

4.  A global trade war, possibly linked to a breakdown between the US and China trade relationship.  This could cause China’s economy to nosedive, dragging with it the surging economies of Australia and Canada.

5. A market trading collapse, in the US, rooted in the failure of high frequency trading that today accounts for almost 70% of trading volume in the equity markets.

6. Geo-political shocks.  Israel-Iran, North Korea, Russia, and several non-government sponsored terrorist organizations could spark a conflict that would probably stun the fragile capital markets.

And the most likely trigger will probably NOT be on anyone’s list, making it seem even more shocking when it occurs. 

The point is that the financial system of the world is being held together by nothing more than bubble gum and tape.  And THIS is the underlying reason that the system will most likely enter into another crises.  The actual trigger is almost irrelevant.  Any number of known, and unknown, shocks can cause the system to collapse again.

And unless the underlying problems are corrected immediately, a collapse is almost guaranteed to occur.

The Demographic Headwinds

March 14, 2010

The S&P500 crept up just under 1 percent last week on low volume.  Although the VIX (or fear) index is at a low (complacent) level, it contradicted the price rise by also rising slightly.  This suggests that traders are buying more insurance to protect themselves against price possible price drops. 

The macro data were mixed to weak.  The US Treasury reported a $221 billion budget deficit for February–the largest monthly deficit ever in the history of the nation.  Initial jobless claims were slightly worse than expected.  The US trade deficit for January was slightly less awful than expected, but this happened more because imports fell than because exports boomed.  And the drop in imports is hardly a good sign for economic recovery.  February retail sales were better than expected, but only because the January sales were revised down so much than the February number suddenly looked better by comparison.  Consumer sentiment was lower than economists had expected, and so were business inventories.

Technically, the S&P’s weekly charts show a strong negative divergence.  While prices have bounced back to January highs, many other leading technical indicators are pointing to an imminent decline from an overbought level.  The daily charts are screaming that equities are overbought and due for some sort of pullback.

Barron’s recently presented a piece from Thomas Kee, who runs Stock Traders Daily.  Mr. Kee researched the correlation between overall stock prices and people’s peak investment cycles.  Specifically, he focused on people, in their mid forties, who tend to maximize their savings rates in preparation for retirement.  Clearly, if more of the population is saving, then the additional flow of funds into the capital markets would tend to be positive for equities.

His findings were strikingly correlated with the major stock market phases–secular bull and bear markets.  The periods of declining investment closely matched the stock market falls in the 1930’s and the 1970’s.

Where are we today?

According to Kee, we’re headed for another stretch of trouble.  His investment rate indicator peaked in 2007 and turned sharply downward since. 

How long might this downturn last?

Prior secular downturns lasted at least ten years, and this demographically driven drop in investment looks like it will last almost 15 years.  According to Kee, the investment rate won’t turn back up until 2023. 

Could it be time to batten down the hatches?

The Federal Reserve Party is About to End

March 6, 2010

The S&P500 moved up 3% last week, but on volume that was–again–lower than that of the prior week’s price drop.  So when prices rise, volume falls; when prices fall, volume rises.  This is not a good signal that new and enthusiastic money is moving into stocks to buy.  If anything, it keeps suggesting that the owners of stocks are inching closer to the exit door.  And volatility also fell to 18 month lows, also suggesting that a rise (in fear) is more likely than a drop.

The economic data were mixed.  Personal income inched up slightly, but less than expected.  Personal spending rose more than expected.  ISM Manufacturing was weaker than forecasted; ISM Non-Manufacturing was stronger.  Initial claims were still elevated, at 469,000.  Factory orders came in lower than consensus estimates.  Headline (U-3) unemployment remained unchanged at 9.7%, but broad (U-6) unemployment rose to 16.8%, near the record highs reached a couple of months ago.  Non-farm payrolls fell 36,000 in February;  January’s losses were revised down to 26,000.  Average weekly hours worked climbed to 33.8, but average wages earned rose only 0.1% when 0.2% was expected.

Technically, the uptrend on the daily charts, while in tact, is becoming toppy.  The downtrend on the weekly charts is still in effect, and the weekly indicators are still displaying a slow-motion topping formation that began late in 2009.

So what could cause traders and investors to actually use the exit door and sell for more than just a couple of weeks?

As noted during the uptrend that began in March 2009, the Fed’s liquidity pump has been almost perfectly correlated with the rally.  And the huge size of the pump also suggests that the Fed’s actions could have reasonably explained the rise of most risk assets, including stocks; the Fed’s quantitative easing program alone pumped in over $1.5 trillion of newly printed (created) dollars into the capital markets. 

So when will these programs end? 

Well, many of the emergency funding programs ended just last month, in February.   The PDCF, AMLF, MMIFF, TLGP, CPFF and foreign swap lines are either fully or almost fully shut down.  Next week, the Fed will end its Term Auction Facility (TAF) program, and on March 31, the Fed will partly terminate the TALF program.  But most importantly, on March 31–only a few weeks from now–the Fed will end its $1.5 trillion quantitative easing program. 

In a couple of weeks, most of the Fed’s massive liquidity pump will be shut off. 

Clearly, nobody can know with certainty that this will kill the price party.  But given that much of the price rise occurred precisely while the Fed’s liquidity party was in full swing, only a fool would not take some precautionary measures. 

The Fed is turning off the music and taking away the punchbowl.  Soon we will see if the remaining guests can keep the party going–all by themselves.