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The Fed's Giant Stride
Sentinel Investments
By Christian Thwaites
December 18, 2012

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The news from this meeting was widely telegraphed (see Yellen, Evans, etc. last month) but produced some real and welcome developments. Here's the quick summary:

1. Low rates language changed from until "mid-2015" to as long as unemployment remains above 6.5%.

Reaction: This is good. The constant date extensions underlined how the Fed was widely amiss on rate forecast. Tying actions to outcomes is a first.

2. The 2% inflation target moderated; the Fed could keep rates unchanged up to a 2.5% rate.

Reaction: Again good. The economy is nowhere close to the 2% rate and the unintended signal to the market had been that tightening would occur as soon as the threshold was broken. This gives Fed actions time to work.

3. Introduction of "well anchored" criteria for inflation which means they won't tighten if there's a commodity-type uptick.

Reaction: Monthly inflation numbers are volatile. Recent scares on inflation in food and gas prices quickly abated so we needed a less rigid inflation target.

4. Added that other "labor market conditions" would drive decisions; take this to mean that headline rate matters but so too do things like employment / population ratio and U-6 rates.

Reaction: There are some fundamental changes going on in the labor market with unemployment falling faster than growth indicators alone would suggest. This gives the Fed room to maneuver if there's slack elsewhere in the labor market.

5. A Treasury purchase program would replace the current maturity extension program at year-end.

Reaction: Good. Twist led to no new money creation but new purchases do. As St. Louis Fed Chairman James Bullard noted two weeks ago, "outright purchases are likely more potent than twist operations." So even though the nominal purchase amounts are the same ($40bn of MBS and $45bn of treasuries), the net result is further easing.

Why the Changes?
Several Fed board members had argued for a change in communication policies. The Fed started forward guidance back in December 2008. Back then, it was about rates staying low for "some time." Wind on to March 2009 and we got the first "extended period" language. Then in August 2011 we saw the "exceptionally low... through 2013" and finally in January of this year, we had the "at least through late 2014" language. Note the trend. Each time the Fed was trying to shift expectations and establish the ground rules of stability. This was of course accompanied by the portfolio rebalancing polices of LSAPs and MEPs. But in all this, it was never clear when or how the Fed would change policy and the fear grew that as soon as the economy grew, inflation climbed or unemployment fell, for whatever reason, policy would change. Abruptly.

So what we now have is commitment to clear target criteria and thus a better understanding of how the Fed deliberates. On top of that the new Treasury buying policies do two new things. First, the Fed has only $20bn of securities maturing in less than one year, so in effect they have nothing left to sell at the front end. In the new program, 68% of the new purchases will be in the four to ten year maturity range so the Fed's balance sheet will end up looking even more back ended. Second, this expands the monetary base by around $540bn in the next year. Remember Twist had no real effect on M2 stock. This seems to follow Friedman's prescription for the Japanese economy a few years ago:

" long term government securities...keep buying them and [provide] high powered money until high powered money starts getting the economy into expansion."

Which is fine but the conditions under which the market unwinds will weigh heavily on the market, which is probably why the first reaction of the long bond was to sell off by around 3% and pop the yield by around 12bp.

The Projections
There can't be much fun in the meetings. The economic outlooks remain cool. Trends matter more than month to month changes. Employing that maxim, we can compare the adjectives used by the Fed to describe the economy twelve months ago and in the recent statement. Spot the difference? No, nor me.


  March 2012 December 2012
Economy Moderate Moderate
Employment Declining but elevated Declined but elevated
Household Spending Advancing Continued to advance
Fixed Investment Advancing Slowed
Inflation Subdued Below objective
Securities Repurchases Maturity extension $40bn pm Outright purchases $85bn pm
Housing Depressed Improvement


Let's have a look at the forecast from a year ago and compare those with the latest estimates:

Variable 2012 2013 2014
Change in Real GDP 1.7% to 1.8% 2.3% to 3.0% 3.0% to 3.5%
   Nov 2011 est 2.5% to 2.9% 3.0% to 3.5% 3.0% to 3.9%
Unemployment 7.8% to 7.9% 7.4% to 7.7% 6.8% to 7.3%
   Nov 2011 est 8.5% to 8.7% 7.8% to 8.2% 6.8% to 7.7%
PCE Inflation 1.6% to 1.7% 1.6% to 1.9% 1.6% to 2.0%
   Nov 2011 est 1.4% to 2.0% 1.5% to 2.0% 1.5% to 2.0%

Source: Federal Reserve Board

The basic story is that growth is slower, unemployment estimates barely changed (although 2012 turned out better) and inflation woefully below target. And finally a year ago, only five out of 18 members thought easing should commence in 2015. Now 13 out of 19 do.

Put all this together and we see the Fed with more room to maneuver, a flexible definition of unemployment and some latitude on inflation definitions. The changes are more stylistic than substantive, for now. But good ones nonetheless.

Finally, putting this into context. We remain in very accommodative territory. Here's the Chicago Fed National Financial Conditions Index which groups various leverage, term rates, spreads and shadow banking stats. Any read below 0 means "looser than average." We're in the same territory as we were in prior asset bubbles.

Source: Federal Reserve Bank of St. Louis, Economic Research

And where's the economy going?
Nowhere fast. First start with the financial balances. The household and corporate private sectors continue to run surpluses. Net private savings are now at $1,200bn, according to the Fed's Flow of Funds report, almost double the 2008 level and net liabilities have fallen by $1,700bn. So saving more and cutting debt means that balances sheets are in slow repair. Here's the run down in liabilities:

Source: Federal Reserve Bank of St. Louis, Economic Research

And with foreclosures, loan forgiveness and recent upticks in house prices, here's the home equity feel-good factor for households.

Source: Federal Reserve Bank of St. Louis, Economic Research

Now add in rising securities markets, lower liabilities and a big increase in time and savings deposits, for the total net worth: back up to pre-crisis levels.

Source: Federal Reserve Bank of St. Louis, Economic Research

So this is all good except that the private sector is struggling with negligible growth in disposable income, still paying down debt and reluctant to return to dissaving on any scale. That leaves only the public sector with a savings deficit and thus filling some of the demand gap. And as we know, that's about to go into negative territory in 2013 as the negotiations are not about whether government spends less but by how much. The fiscal drag in 2013 is likely to be around 1.5% of GDP. That's quite a change because for the last two years, it has been around 0.5% (which includes the big pull backs from state and local government). As all the sectors (so that's public, households, corporate and foreign) in the economy must balance, and with three out of four in full savings mode, the outlook for stronger, higher, faster income growth is pretty flat.

And that showed up last week where we saw small business optimism, in the NFIB survey, pull back six points to one of its lowest levels since 1986. The biggest detractor was the answer to the simple question of "do you think business conditions will be better in six months?" The overwhelming response was "no" with a volume almost twice that of early 2009.

Trade also took a hit from the global slowdown. The higher deficit is equivalent to about a 0.1% drag on growth. Capital goods exports fell 4% and imports from China rose. Why? Well the iPhone 5 is made there and shipping started on September 21st. So this is what it looks like when your favorite smart phone is counted in the balance of payments:

Source: Federal Reserve Bank of St. Louis, Economic Research

Other news this week saw slower retail sales, a bounce back in industrial production (but with the prior month revised down), and a very slow producer and consumer price change, less than 2% in both cases. That leaves the Fed room to focus on efforts to boost activity in the real economy.

A relatively quiet week. The EU met, talked about more fiscal and banking union but didn't mention it in their final communication. Bond yields held steady. Even the Italian 10 Year recovered from the Monti resignation announcement. As 2012 closes, one loud and clear theme has been the resilience of the euro concept and unity despite numerous commentaries on break up inevitability. We hear that some hedge funds have gone seriously underwater betting that the Hollande policies in France would lead to a massive bond sell off. No such luck. French 10-year bonds returned 14% so far this year.

There's a lot of auction pressure right now with the whole curve out for bid last week and this. So last week we had auctions of 3s, 10s and 30s. Next up are 2s, 5s and 7s. Last week's 30-year auction was lukewarm with a bid/cover ratio below the average of the last four. Stepping back, this shows the income to total return ratio in the 10-year bonds and the S&P[1] in the last two years.

Asset   YTD 2 Years
  Yield 2.8% 3.3%
  Total Return 4.6% 21.5%
  Yield/TR 40% 15%
  Yield 2.5% 4.9%
  Total Return 16.0% 18.5%
  Yield/TR 15% 26%

Source: Bloomberg

Note that you would normally expect bonds to provide the stability of principal and surety of income. But right now, the risk is very skewed towards price action...and price action that can wipe out yields in an intraday move. The numbers for the S&P look far more solid, especially factoring in some dividend growth.


Fiscal Cliff
If there's no deal, payroll taxes go up and extended UI disappears. This hits the lower-paids hard. Expect a drop in personal disposable income the first paycheck of January.

Bottom Line: With all the news items, the markets barely moved on the week. The Fed news is of longer significance, and meanwhile we have the dance to the music of cliffs to entertain us. We had an almost straight line upturn from the post election lows. The market has increased 4.5% in less than a month and YTD performance is around 15%. No one wants to risk the gains booked so far. We expect low volumes for the remaining sessions and are making no changes to allocations. So that's a moderate overweight to equities and corporates.

We'll review our 2012 forecasts the first week in January. Suffice to say some worked, some didn't. But the one I was most confident about dinged: Casey Stoner nerfed himself off his machine at 130mph and had to sit out four rounds. So the MotoGP crown went to the Spanish diehard, Jorge Lorenzo.

In closing, a tragedy. One that leaves us yearning and uneasy. Such wickedness has no meaning or reason. Our thoughts are with all those touched by the horrors of Newtown, any town.

Sources: Bloomberg, US Bureau of Economic Analysis, US Department of Commerce, FT Alphaville, Capital Economics, Economist Free Exchange, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago, Federal Reserve Board, J.P. Morgan Market Intelligence, CRT Ader, High Frequency Economics, European Commission, European Central Bank, US Census Bureau, Pantheon MacroEconomic Advisors, TrendMacro, Bureau of Labor Statistics, Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.


(c) Sentinel Investments



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