Last week, the Federal Reserve announced their latest non decision making no changes except in verbiage, and will continue printing $85 billion of new money each month. This was despite the fact that in several statements by fed officials, including those of the chairman on May 22nd, indicating some eventual reduction of this amount.
There were two issues that became apparent, the first was the previous pattern of acting on the informal fed speak at the next meeting was different this time, Was it because the previous statements all were adding stimulus and were well received and this one was removing stimulus and the market was shaken at this prospect? It certainly calls the leadership of the fed into question as they may very well be reacting to the same short term market movements that they themselves are causing. The second issue is the policy itself, is it just a rationalization for a maximum stimulus or a real policy?
Last fall, “Operation Twist” was “continued” which is interesting semantics as the twist both bought and sold having only the net effect of extending the duration of the government bond portfolio and this “continuation” changed that to buy only, and doubled the amount of printing. We were told it was exactly the right amount of stimulus and it would be targeted and surgical. Repeatedly at news conferences and congressional hearings this was represented as being very successful in re-inflating exactly what they wanted to re-inflate and having no other impact. In fact, anyone who has gone past economics 101 realizes that these tools are very blunt instruments and using them is very similar to typing with mittens – you may very well be hitting the right key but you are also hitting many other keys as well. But yet we were told that $85 billion per month of new money was exactly the right amount due to the state of the economy at the time.
At this past fed meeting, the statement indicated that economic risks were not as great as last fall and there were improvements in employment and growth, but yet the proper amount was still $85 billion per month. Was this a rational statement, or a rationalization of a previously determined amount? The mentality is that we should pump and pump and continue to pump up to the point – but not exceeding the point – of causing a bubble. This is the topic of most of the time the fed spends before congress – keep doing what you are doing – but define a line of where a bubble starts, and then do not cross it. When has any government or fed official been able to spot a bubble prior to it passing in the rear view mirror? When is it ever a good idea to use a temporary policy to push the market to a level other than where it would otherwise be? Sooner or later, finance 101 takes over and a stock should be worth the present value of the expected cash flow. If we do not believe that, the market has stopped being a capital raising and allocation tool and become a casino.
After the fed announcement, and prior to the carefully orchestrated fed speeches of this week, the market continued down, led by the consistent selling of the bond market and the corresponding increase in interest rates. The worst scenario would be if the bond market starts to impose its own discipline. If this happens, there could be sudden, and potentially drastic movements in interest rates that could have massive implications on personal, corporate and, most immediately, sovereign debt servicing costs. Hence, the desperation and coordinated series of fed speeches saying that the market is misreading the fed, and they probably are, as the fed will never take the punch bowl away voluntarily, at least under the current management. This past meeting was the best and maybe the last best chance, of the fed to start to escape from the single biggest mistake of the management of this past and current financial crisis, the doubling of the money printing last fall, on a gradual and measured pace.
Since the full dollar amount of the continuation of the twist was first revealed on November 16th, (which just so happened to correspond with the start of the current rally) the SPY rose over 25% till the tapering comments on May 22nd, (the IWM over 30% in the same time frame). The market increased over 25% in six months (a 50% annualized rate) and this is in an environment where the GDP grew 0.4% in the Q4 2012 and 1.8% in Q1 of 2013 with a modest increase in the second quarter expected. So the question is not whether the market can sustain a rate of growth over 25 times the rate of growth of the economy, but rather when and how will this end?
The financial management of our economy has had three basic legs, deficit spending, zero interest rates and money printing all of which can be effective short term emergency tools. Unfortunately all of these can become counter productive and even destructive if used in excess and the people in charge of our financial policy are continuing to use them as if they were the only tools in the toolbox. One of the reasons stated for continuing the money printing unabated was the fiscal headwinds. Although it is true that late last year we were spending $1.40 for every $1 brought in and because of higher payroll tax receipts, the payroll tax increase and the sequestration, we may “only” be spending $1.30 to $1.35 for every $1 taken in, that is not austerity. Austerity is spending less than you make to pay down debt and we are not even in the same area code as that. Zero interest rate policy is another over the top policy. Any interest rate that is below the rate of inflation plus a normal real return is accommodative. Rates could be several percent higher and still be accommodative – so why does it have to be zero? Initially this was great for banks as their cost of capital (or cost of goods sold for them) became zero, but long term this is not great as what banker would make a large amount of long term loans at a rate below their historic long term cost of capital? You are seeing this trend in the significant decrease in the amount of bank earnings coming from the normal banking function of making loans.
The other side of the zero interest rate is the net lenders, the older middle class that are forced decide between a negative real return for the past several years or follow the regional fed president’s advice of taking more risk. That advice did not work well the past several weeks and many high dividend stocks, MLP’s and REIT’s are down significantly due to interest rate increases. Many were forced to sell as they violated their risk profile in the sell off. I hope they call their local fed president instead of their broker to complain about that advice. And of course there is the money printing of the various QE’s. Initially, printing money to buy bonds lowers interest rates but too much of this raises inflation expectations and interest rates. All three of these tools, when initially proposed were all supposed to be extraordinary measures for an extraordinary time of financial emergency. “Extraordinary” may have been the most used word in the fed chairman’s comments introducing these programs followed next by the word “temporary”.
So how are we doing with those “extraordinary” and “temporary” programs? Right now we have a level of positive growth we want to increase and a decreasing level of unemployment that we want to decrease further – well that sounds fairly normal and ordinary, so why the extraordinary measures? Two reasons, the independence of the fed is an illusion and they fear a double dip if the “extraordinary” and “temporary” measures are removed. So these programs become a normal part of the investment landscape to be exploited as the fed has your back and pushing the market up becomes a national goal (Wednesday’s big market rise on the fact that GDP was revised down almost 25% as it gives the fed “cover” to print more – wonderful logic to run an economy). Imagine the successful graduation rate from a rehab clinic (which the fed should be emulating) if the entire process involves hoping for setbacks in order to increase medication and measuring your performance by the number of people still in the program. For the entire time that the current fed chairman has been in that position there has been one constant and that is the thought that what he fears the most is a repeat of 1937 when the fed, in his opinion, tightened prematurely. Well it now appears likely that there will not be any decrease of accommodation at all while the current fed chairman is in office but it is not yet apparent whether the history books will think kindly of that singular goal.
So, the decision for investors (or players in this game of musical chairs) is either to buy, knowing the guy responsible for stopping the music periodically is not on the job, or should you fear the impending storm outside, knowing that it will eventually knock out the power and stop more than just the music.