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Europe, Washington and Wall Street

Published 01/30/2012, 05:20 AM
Updated 07/09/2023, 06:31 AM
Last time I wrote, “The Fed’s Open Market Committee meets next week and there is a little buzz they may tinker with their previous statement they would keep short-term rates at zero well into 2013. A change in the language could lead to some volatility.”

Well, the volatility didn’t occur but Chairman Ben Bernanke and his band of Fed governors did indeed tinker with the language; as in now the Fed says it will hold rates at zero until late 2014, or maybe it won’t.

You see, for the first time the Federal Reserve released the individual forecasts of all 17 Fed officials and six of them believe the Fed will begin increasing rates again before 2014, so it’s not like the Fed is really committed to hold rates down as it told you and Bernanke later conceded as much in his press conference. What the Fed is looking for, however, is to keep long-term interest rates as low as possible for as long as possible until a housing recovery takes hold; such a recovery being necessary if the U.S. economy is ever going to take off again.

You see, on Friday the flash estimate on fourth-quarter GDP came in at 2.8% growth, or the sixth straight quarter below 3%. On countless occasions I’ve pointed out how during the Reagan recovery off the 1981-82 recession, we had six straight quarters of growth above 5%. Oh, what the heck…one more time. Dedicated to the Gipper with love.

1983
Q1…5.1%
Q2…9.3
Q3…8.1
Q4…8.5 1984
Q1…8.0
Q2…7.1 And…

2010
Q3…2.5
Q4…2.3 2011
Q1…0.4
Q2…1.3
Q3…1.8
Q4…2.8

Hey, look at that steady progress the last few quarters. Outstanding! Then again, this is all the White House probably needs to get the chief occupant re-elected…enough growth to enable the unemployment rate to tick down a little more…say from the current 8.5% to 8.2%.

After all, it’s about trends and sentiment. In the latest Wall Street Journal/NBC News poll, 30% of the people believe the country is headed in the right direction. Hardly a positive for the White House…but it’s eight points better than just a month ago. 60% believe the nation is on the wrong track, but that figure was 74% in October. President Obama’s job approval is up to 48% and for the first time in seven months, more people approve of his performance than disapprove (46%).

On the economy, 37% expect it to get better over the next year, 17% say it will get worse. Just last month, optimists outnumbered pessimists by only a 30 to 22 margin.

But back to the Federal Reserve, if the economy continues to show improvement, however haltingly, they will hike rates before 2014. That’s a guarantee, even if inflation stays tame, because that would mean housing is finally recovering. In the meantime, the Fed chairman couldn’t give a damn about those of you on fixed income who thought you were doing things the right way all your lives…saving and putting that money in a secure instrument, such as a savings account, CD, or money market fund. I keep using the example of a $100,000 nest egg that would supplement one’s Social Security check. At 2% that’s $2,000 a year, $40 a week. That’s a lot for someone in that situation. Take the wife out to a movie and McDonald’s for some simple enjoyment, for example. “It’s our date night,” you’d tell the neighbors with a smile.

But not today. Ben Bernanke said in his press conference that he understands “savers are getting a lower return.” Try zero, Ben! Bernanke explains, “Savers are dependent on a healthy economy to get good returns…low interest rates are needed to restore the economy, which in turn leads to higher returns on all assets.”

Some of us just want to scream. It can only be an academic exercise, but after we had turned the corner in 2009 following what was then the Fed’s appropriate zero interest rate policy to prevent Armageddon, the Fed should have normalized rates; 2% on the funds rate. No way the 10-year in that scenario would have then been above 4%, so historically low mortgage rates would have still been the norm for prospective homebuyers. Any hints of inflation would have been extinguished. The dollar would have been stronger and chances are the commodity bubble of 2010-2011 wouldn’t have occurred, which did a number on food and fuel prices. Yes, it’s all hypothetical, and even I won’t tell you what I received in my Economics or Finance classes back in school. One thing I can guarantee, though, shares in McDonald’s would have been even higher than they are today. Mohamed El-Erian / Financial Times
“Policy experimentation continues unabated in the U.S. with the Federal Reserve launching on Wednesday a new initiative to influence market valuations and, through this, the outlook for the country’s economy. The Fed hopes to use greater transparency to mould expectations in a manner that promotes economic growth and price stability. But this new approach could also create confusion and even greater hesitancy on the part of healthy balance sheets to engage in productive investments….

“On Wednesday, the Fed showed how it intends to use ‘communication’ as a much more active tool to inform and influence economic outcomes. But this approach goes well beyond the concept of greater transparency. By publishing members’ individual forecasts – specifically, the annual evolution of the policy rate, the timing of the first hike and a long-term natural rate – the Federal Open Market Committee wants to provide a firmer and steadier outlook to encourage investors, in both physical and financial assets, to commit to long-term decisions.

“Few expect this new initiative to have an immediate or durable impact. Beyond 2012, individual FOMC members’ forecasts are quite dispersed, including a 0.25% to 2.75% range for the target Federal Funds rate for end of 2014….

“We need to see a significant clustering of FOMC member forecasts that could credibly translate into a medium-term vision for policy rates, and greater responsiveness on the part of households, companies and investors to price movements. But even these will not prove sufficient unless the Fed’s continued activism is part of a more comprehensive policy response out of Washington. As yet, there is little to suggest that we are moving quickly enough to meet this requirement.” Editorial / Wall Street Journal

“The two most powerful men in Washington have a big disagreement. No, not President Obama and Speaker John Boehner. We mean Mr. Obama and Federal Reserve Chairman Ben Bernanke, who can’t seem to agree on the health of the U.S. economy.

“On Tuesday night, the President proclaimed that the ‘state of our Union is getting stronger,’ employers are hiring faster than they can find skilled workers, and manufacturing is booming. Less than a day later, Mr. Bernanke and his Open Market Committee downgraded their already modest growth outlook and said the recovery is so vulnerable that the Fed must keep interest rates at near-zero for another three years.

“The contradiction may not be as profound as it seems. Mr. Obama is running for re-election and this time he needs to sell austerity more than hope, while the Fed is still trying to reflate the housing market that it seems to believe is the main driver of economic growth. The Fed is straining to deliver the asset-price ‘stimulus’ that Mr. Obama can’t any longer get out of Congress….

“The central bank had already promised to keep short-term rates near-zero through most of 2013, but now it feels the need to assure investors it will keep them there through the end of 2014. That would be six years in total, more than half of what may eventually become known as the Fed’s Zero Decade.

“Mull that one over: The Fed is declaring that it needs to run the same super-easy monetary policy when the economy is growing by 2% or 3% as it did amid the worst of the financial panic….The unavoidable implication is that the Fed doesn’t think the economy will grow any faster until what would be halfway through Mr. Obama’s second term….

“But intervening so directly to keep rates artificially low has made the bond market useless as a price signal or indicator of risk across the larger economy.

“The Fed is thus pushing investors of all kinds further out on the risk curve with consequences no one can foresee – least of all the Fed, as we are now learning from the just-released FOMC transcripts from 2006.

“Recall that during the last decade the Fed assured everyone there was nothing to worry about as it kept rates too low for too long, only to create a housing bubble it never did recognize. Recall, too, how its second round of bond-buying (QE2) in 2010-2011 was supposed to lift stock prices but in addition sent commodity prices soaring. Consumer confidence plunged as Americans felt the strain of higher prices for food and energy, and the economy has done notably better since QE2 ended.

“Where will the risk-taking excesses show up this time? Who knows.”

One thing we do know about the Fed’s interest rate policy. It’s holding down the level of interest expense on the budget deficits. In combination with Europe’s woes, Treasuries have been the place to be and that will continue to help Treasury as it sells an estimated $970 billion of bonds in 2012, according to Credit Suisse. As economist Ed Yardeni told Bloomberg:

“The Fed has been the great enabler of the government’s fiscal excesses. The Fed’s zero interest rate and quantitative-easing policies have squelched any protests by the bond vigilantes.”

But, the debt load continues to rise and interest expense will rise as well, to $474 billion this year, according to the Office of Management and Budget. Imagine when interest rates finally take off, not that I’m forecasting that any time soon, though the debt crisis will hit home at some point this year and I’ve told you what will happen then.

As to the U.S. economy and the latest data, December durable goods rose a better than expected 3.0%, but new home sales for the month were less than expected as was the leading economic indicators figure for December. Jobless claims for the past week also rose substantially off their multi-year lows. And you had that 2.8% GDP number that contained less than sterling personal consumption and consumer spending data, as well as a troubling increase in inventories that could augur for diminished manufacturing activity the first half of this year. At least the inflation component of the GDP report was good.

The week also saw another slew of earnings reports and while the likes of Apple and Caterpillar were excellent, many of the others were so-so at best, or, as in the case of McDonald’s, the stock may just be getting a bit pricey. Additionally, Chevron’s big miss on Friday didn’t help matters.

Which leads me to the State of the Union (SOU) address. In reporting on it, one thing is easy. President Obama is always good when it comes to leaving out the details so I don’t have to get many down for the record. It’s just nice to know “America is back. Anyone who tells you our influence is in decline doesn’t know what they’re talking about.” And, “America remains the one indispensable nation in the world and I intend to keep it that way!” U.S.A! U.S.A! Lead from Behind! Lead from Behind!

The president did pull out his class-warfare rhetoric, though to be fair it wasn’t quite as partisan as it could have been. But in providing the one detail of the evening, that millionaires would have to pay an effective tax rate of 30% (the ‘Buffett rule’), he also talked of those earning $250,000 having to pony up more but here there were no details as to how he intends to fill the gap. Editorial / Wall Street Journal

“The White House says that if a millionaire household’s effective tax rate falls below 30%, it would have to pay a surcharge – in essence a new Super Alternative Minimum Tax – to bring the tax liability to 30%. For those facing this new Super AMT, all deductions and exemptions would be eliminated except for charity.

“The Buffett rule is rooted in the fairy tale that taxes on the wealthy are lower than on the middle class. In fact, the Congressional Budget Office notes that the effective income tax rate of the richest 1% is about 29.5% when including all federal taxes such as the distribution of corporate taxes, or about twice the 15.1% paid by middle-class families.

“This is because wealthy tax filers make most of their income from investments. Such income is taxed once at the corporate rate of 35% and again when it is passed through to the individual as a capital gain or dividend at 15%, for a highest marginal tax rate of about 44.75%....

“One implication of the Buffett rule is that all millionaire investment income would be taxed at the shareholder level at a minimum rate of 30%, up from 15% today….

“The new 30% capital gains rate would be the developed world’s third highest behind only Denmark and Chile…This is on top of the 35% corporate rate that is already the second highest rate in the world after Japan. That giant sucking sound you hear come January 2013 would be hundreds of billions of investment dollars fleeing to China, India, Korea and other U.S. competitors.”

As Jennifer Rubin reports in the Washington Post, citing a Gallup survey:

“About half (49%) of Americans agree with President Barack Obama’s claim that the U.S. economic system is unfair, while 45% say it is fair. At the same time, 62% say the U.S. economic system is fair to them personally.” In a separate piece, Ms. Rubin observes of the SOU: “Where is his entitlement reform? Where is his tax-reform plan? He can’t be bothered with actual governance.”

And then there was the Republican rebuttal to Obama, offered up by Indiana Gov. Mitch Daniels.

“In three short years, an unprecedented explosion of spending, with borrowed money, has added trillions to an already unaffordable national debt. And yet, the president has put us on a course to make it radically worse in the years ahead. The federal government now spends one of every four dollars in the entire economy; it borrows one of every three dollars it spends. No nation, no entity, large or small, public or private, can thrive, or survive intact, with debts as huge as ours.

“The president’s grand experiment in trickle-down government has held back rather than sped economic recovery. He seems to sincerely believe we can build a middle class out of government jobs paid for with borrowed dollars. In fact, it works the other way, a government as big and bossy as this one is maintained on the backs of the middle class, and those who hope to join it….

“The routes back to an America of promise, and to a solvent America that can pay its bills and protect its vulnerable, start in the same place. The only way up for those suffering tonight, and the only way out of the dead end of debt into which we have driven, is a private economy that begins to grow and create jobs, real jobs, at a much faster rate than today.

“Contrary to the president’s constant disparagement of people in business, it’s one of the noblest of human pursuits. The late Steve Jobs – what a fitting name he had – created more of them than all those stimulus dollars the president borrowed and blew. Out here in Indiana, when a businessperson asks me what he can do for our state, I say, ‘First, make money. Be successful. If you make a profit, you’ll have something left to hire someone else, and some to donate to the good causes we love.’

“The extremism that stifles the development of homegrown energy, or cancels a perfectly safe pipeline that would employ tens of thousands, or jacks up consumer utility bills for no improvement in either human health or world temperature, is a pro-poverty policy. It must be replaced by a passionate pro-growth approach that breaks all ties and calls all close ones in favor of private sector jobs that restore opportunity for all and generate the public revenues to pay our bills.

“That means a dramatically simpler tax system of fewer loopholes and lower rates. A pause in the mindless piling on of expensive new regulations that devour dollars that otherwise could be used to hire somebody. It means maximizing on the new domestic energy technologies that are the best break our economy has gotten in years….

“No feature of the Obama Presidency has been sadder than its constant efforts to divide us, to curry favor with some Americans by castigating others. As in previous moments of national danger, we Americans are all in the same boat. If we drift, quarreling and paralyzed, over a Niagara of debt, we will all suffer, regardless of income, race, gender, or other category. If we fail to shift to a pro-jobs, pro-growth economic policy, there will never be enough public revenue to pay for our safety net, national security, or whatever size government we decide to have….

“In word and deed, the president and his allies tell us that we just cannot handle ourselves in this complex, perilous world without their benevolent protection. Left to ourselves, we might pick the wrong health insurance, the wrong mortgage, the wrong school for our kids; why, unless they stop us, we might pick the wrong light bulb!...

“There is nothing wrong with the state of our Union that the American people, addressed as free-born, mature citizens, cannot set right…a program of renewal that rebuilds the dream for all, and makes our ‘city on a hill’ shine once again.”

Europe

In its latest policy statement, the Federal Open Market Committee warned:

“Strains in global financial markets continue to pose significant downside risks to the economic outlook.” Gee, I wonder who the Fed is alluding to? Europe, perhaps? Oui oui.

This was a week that started out with positives, as a combined eurozone reading on manufacturing and the service economy for January was above the 50 line, 50.4, with Germany at 54 and France 50.9. But the figure on manufacturing alone was 48.7 for the region, so still in contraction territory. And despite the fact Italy had some successful bond auctions, with its rates coming way down on the short end, as well as seeing its 10-year trade below 6.00% for the first time since December, Italy still has 450 billion euro to go this year in terms of rolling over its debt and financing the massive deficit.

Much is being made of the success of the European Central Bank’s Longer-Term Refinancing Operation, or LTRO, that injected 489 billion euro into the banking system in December. A second LTRO is slated for February 29.

No doubt, in the short run the ECB’s ‘Fed-like’ move has stabilized the banking system in terms of what was a distinct funding crisis end of 2011, a la Lehman. The system had freezed up. Banks weren’t lending to each other.

Well they still aren’t to any large degree, but the ECB’s infusion, at a 1% lending rate for 3 years, did strongly encourage the banks to go out and use the cash to buy sovereign debt, such as that of Spain and Italy, with much higher yields. Nice spread, eh?
But not all the cash is being used in such a fashion. First off, much of it was used to just refinance the banks’ short-term obligations. Much of the rest of it is being hoarded. It’s why S&P is projecting that Europe’s default rate may soar to 8.4% or worse, from 4.8% at the end of 2011. The lending window is closed, especially for small business, highly-leveraged businesses (read risky private-equity deals from the mid-2000s), and generally anything in southern or eastern Europe. I would argue that while Spain and Italy have caught a break for the time being, and as stocks rally on the continent, the contagion is most definitely spreading. 
Just on Friday, Fitch knocked down the credit ratings of Italy and Spain again, along with those of Belgium, Slovenia and Cyprus,

having previously telegraphed their actions back in December. Fitch noted:

“The divergence in monetary and credit conditions across the eurozone and near-term economic outlook highlight the greater vulnerability” these nations face in the event of financing shocks.

This past week saw the same old arguments re-emerge. The IMF wants Europe to adopt a greater firewall for the likes of Italy and Spain and German Chancellor Angela Merkel doesn’t want to contribute more resources and guarantees. British Prime Minister David Cameron concurred with the IMF’s Christine Lagarde in blasting Merkel at the World Economic Forum, stressing that while progress has been made, a much stronger firewall was needed to prevent contagion.

U.S. Treasury Secretary Timothy Geithner echoed the IMF and Cameron in his own comments at the WEF, saying, “The only way Europe’s going to be successful in holding this together, making monetary union work, is to build a stronger firewall.”
Get the picture? Europe remains a house built with sticks when it needs one built with bricks. But it seems leaders won’t reassess the size of the bailout funds already in place until they meet in March.

And there’s the issue of growth. With the austerity cuts and ongoing credit crunch, it’s hard to see where it’s going to come from. Even a shallow recession, if Europe is lucky, needs to be followed by robust growth or the crisis will be never-ending.

Finally, there’s Greece. It doesn’t go away. In fact it just gets worse. The nation is in Depression and the technocrat-led government is in full panic mode, needing to get private bondholders to agree to a restructuring of about a 1/3 of its sovereign debt or Greece won’t be eligible for more bailout funds come March and would thus default. Those, like JPMorgan’s Jamie Dimon, who say a Greek default wouldn’t be that harmful are nuts. You never hear anyone talk about the pictures we’d see on our television screens. You want to see riots? They’ll be as ugly as any you’ve seen in your lifetime, and they would spread, like to Romania, Albania and Bulgaria, for starters. It’s the Balkans, after all.

One must hope an agreement on debt restructuring is reached this week, though that would still in no way be the end of the problem for Greece and the eurozone. It would just supply more short-term relief.

Consider this, after all. The Financial Times on Friday got hold of a copy of a German government proposal that calls for Greece ceding sovereignty over tax and spending decisions to a eurozone ‘budget commissioner’ before Germany would allow Greece to secure a second 130 billion euro bailout.

“In what would amount to an extraordinary extension of European Union control over a member state,” write the FT’s Peter Speigel and Kerin Hope, “the new commissioner would have the power to veto budget decisions taken by the Greek government if they were not in line with targets set by international lenders. The new administrator, appointed by other eurozone finance ministers, would take responsibility for overseeing ‘all major blocks of expenditure’ by the Greek government….

“Athens would also be forced to adopt a law permanently committing state revenues to debt service ‘first and foremost.’”
Such a proposal has long been rumored, and Greek voters are already upset at existing EU representatives looking over their shoulders as every decision is made, but this would cross the line in their minds.

So the crisis continues, even if it’s been just simmering the past 4-6 weeks. It will boil over again.

One other item non-related to Greece and the euro. As I explain below, this coming week is a crucial one with regards to the Iranian nuclear program. This could be the lead for my next review.

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