Traders Blog

Manifest Destiny

Kirsten O'Farrell — Wed, 24 Nov 2010 22:14:02 +0000

Troubling as the Korean squabble may be, more troubling is the European Sovereign debt crisis… even if the US equity markets are ignoring both today, giddy about the approach of the holiday shopping season as well as focusing back on positive jobs data here at home. Ireland released details of its 4-year austerity plan today as officials negotiate the bailout package offered by the EU and IMF. The troubling part of it is that not only are the same doubts about execution as the Greek plan but the Irish, angry at their own government for necessitating the loss of sovereignty, are protesting while their ruling party collapses from the inside. The crisis is far from over. Analysts are calling for further widening of sovereign debt spreads and further volatility in the Euro.

Although treasuries were buoyed yesterday by a flight to safety bid, the back-up in yields resumed today, compounded by weak 5 and 7-year auctions. Obviously, this is not in alignment with the Fed’s goal of downward pressure on long term interest rates which was reiterated yesterday in the minutes of the last meeting. For some economist responses to the minutes see Economists React: Fed Failing on Both Sides of Mandate.

Other highlights from the minutes included the effect on the dollar, the possibility of an undesirably large increase in inflation, and the use of communication as a policy tool. The latter is rather ironic given the amount of criticism the Fed has received since Ben announced that equity market strength was a goal of QE2.

Maybe it’s a stretch I kind of see a resemblance to the justification of the Mexican-American War as a byproduct of inevitable American expansion in the 1800’s. Expansion of the Fed’s balance sheet leading to a weaker dollar and thereby fueling the “currency war” and foreign criticism is ok if it helps us reach our goals. But it’s not. Not entirely.

The run-up in yields and the dollar might be our signal that either the market doesn’t believe they will complete the whole $600B, that its potential effectiveness is wavering, or that the inability of market to absorb the exit means inevitable unruly inflation. The latter two are more likely the case. The selling has gone on longer than if it were just a correction of the rally leading up to the announcement and most believe the possibility of not completing the program is slim given their gloomy forecasts and disappointment with the speed of recovery.

The minutes offered little in the way of clarification as to what benchmarks will signal the decision to increase or decrease purchasing plans but a streak of bad data could certainly spark the critics to quiet down a little. A paper in the Economist by Harvard economics professor Robert Barro outlines why he thinks the Fed’s exit strategy of raising interest rates on reserves to that of T-Bills will be ineffective at preventing an inflation problem. It’s a little thick but worth the read: Thoughts on QE2.

Meanwhile, stocks marched higher in the pre-holiday lack of volume, seemingly ignorant of Korea and the Euro zone, and in spite of the dollar’s rise today. Does it mean stock market strength is resilient? Probably not. It’s too early to tell but I wonder if it disappoints the Fed less that yields and the dollar are rising since inspiring stock market strength was a goal. Doubtful. Regardless, stock market strength today was due to initial jobless claims falling to 407K, their lowest since July 2008, and the retail sector showing better than expected earnings. I think it’s a little hasty to assume it means unemployment is falling but it’s a good sign nonetheless. We get employment figures next Friday and this number is likely to cause some upward revisions to forecasts. I’m leaning toward thinking it’s because of early holiday hiring and we shouldn’t get too excited. But maybe I’m a Grinch.

As I sign off, the yields of all maturities are up between 8 and 10 basis points on the day, the 2-10yr curve is steeper at 238.4, gold is flat-lined at 1374, and the dollar is off its highs but still up 9 cents on the day to 79.85. This stocks up, yields up, dollar up scenario is bad for the Fed’s plans, not to mention downright strange given the geopolitical environment. But at the very least employment data and the equity rally today will put shoppers in a good mood for Black Friday. Good numbers out of Black Friday could inspire still more giddiness in equities. Here’s to you, consumers. Your destiny is in your hands.

Bernanke the Rainmaker

Kirsten O'Farrell — Fri, 12 Nov 2010 19:50:28 +0000

We are ending the week with widespread selling in the dollar, treasuries, commodities, and equities, all on a day where both the Fed started QEII and the G-20 Seoul Summit came to a close. There was increased volatility ahead of the G-20 Summit, as one might expect given the tensions surrounding restorative monetary policy, namely ours. Foreign exchange rates and trade deficits were the topics at hand and this meeting was viewed with hope as the crescendo to attempts at cooperation. But it wasn’t. The Financial Times called the meetings a stalemate, which means no one goes home happy.

There was the usual finger-pointing at China for its prevention of natural renminbi appreciation but we make it easy to point back. Among others, China and Germany have expressed criticism regarding the two-fold bi-product of further quantitative easing. The Fed is accused of stealthily disguising dollar devaluation as the attempt to combat too-low inflation. Then the intention to push interest rates on riskless assets to unattractive levels and thus encourage investors to seek yield from riskier assets has encouraged dollars to be invested abroad, causing interest rate problems for developing nations. Bernanke is a rainmaker, just not for us.

In an article in Thursday’s FT Alan Greenspan is quoted saying the US is pursuing a policy of dollar weakness. Treasury Secretary Tim Geithner continues to reiterate his position by saying the US would never deliberately devalue its currency to boost exports. However, that is the effect and I don’t imagine it’s bothering him at all. Both Angela Merkel, German chancellor, and Zhang Tao, of the PBOC, are quoted criticizing the US for possibly causing others to suffer while it fixes itself. Tao says that the US “should not force others to take the medicine for its own disease.” Not only that, but dollars going abroad take away from the already questionable efficacy of the money-printing solution.
So is China right and the US the bad guy now? Still no. Merkel doesn’t agree with China either but just doesn’t like the way we go about trying to persuade them. Greenspan articulates the fairest reason for renminbi appreciation I have heard. “China has become a major global economic force in recent years but it has not yet chosen to take on the shared global economic obligations that its economic status requires,” he said right after China’s trade surplus surged again in the month of October to $27.1B.

Maybe a stalemate is pretty understandable. Protectionist undertones are pretty strong. What if the Fed didn’t announce more QE at the conclusion of the last meeting? Some would say they had to. It’s important for all markets, all industries, and all economies that they not rock the boat. After all, we are still the hub of world commerce. Really that’s the only thing they absolutely have to do, not rock the boat. The rest is circustantial and can be modified to suit current conditions so long as nothing catostrophic occurs. So they had to announce what the market expected. Did they create the expectation? Well sure. So the answer to that is also no. They did not have to announce more QE. And recent behavior of the dollar might lead one to believe total implementation of all the fresh new QE is not going to happen.

It must be frustrating for the other G-18 that the US and China have to bicker so. But, although the Seoul Summit and series of meetings leading up to it ended without defined agreement they did help shed light on the fact that China has to play by the rules so the US can recover. Just kidding. But protectionism is a real threat.

What You Believe, the Fed Can Achieve

Kirsten O'Farrell — Thu, 04 Nov 2010 22:27:19 +0000

Are we expected to put the potential unintended consequences of QE aside? With the Fed using the perception that it has the ability to unleash more QE as a tool the answer to that is yes. Bernanke has come out and said that one intention of the latest policy move to add an additional $600B of belly treasuries to the Fed’s balance sheet is to encourage stock market investment and thus confidence. Prior to this I thought it was a kind of welcomed side-effect but now it’s a stated goal.

Stock market gains normally boost business and investor confidence but there are a few reasons many question how this will work. First, businesses feel richer when their stock prices go up but what about when prices of the commodities they need to run their businesses also go up because the dollar is forced under pressure by Fed buying? Then what about the foreigners they want to sell their goods to? A boost in exports resulting from the cheap dollar would be nice but not if the excess liquidity created here gets invested in importing countries, causing their economies to overheat and thus raise interest rates and compound the problem. More protectionism won’t help our export business. Forcing investors out of safety assets because they yield nothing doesn’t necessarily buy stocks it just forces them to look for yield elsewhere, which can mean the safety assets of other countries.

Bernanke specifically talks about the rise in stock prices that resulted from anticipation of the most recent action. However, this is based on perception of intended consequences, which are to encourage lending, lower mortgage rates, encourage business investment, and promote job growth. He’s betting that creating the perception that it will work will make it work and that is the heart of new criticism. If it doesn’t work we’ll have, among other things, some very mad foreign central bankers (which we will likely see anyway at the G20 summit the weekend after next), and still the risk of an unruly inflation problem (which Bernanke thinks is quite overstated). If it does work at all he will go down as one of, of not the, most brilliant money man in history. See: Bernanke Bets on the Power of Money, WSJ, How It Works; When it Doesn’t, WSJ, and QE Blunderbuss Likely to Backfire, El-Erian, FT.

In the meantime, we now have Republican control of the House, which might put more political pressure on the Fed. I don’t get the impression they’re going to play along with the façade being created here. It seems more likely that their going to attack that lack of transparency as the root of the problem but I also think that’ll take a backseat to tax cut extensions and war on that healthcare bill.

Tomorrow would normally my favorite day of the month, Employment Friday, but this week we had Election Day and a Fed meeting so I’m spoiled. The street is calling for a benign +60K, 9.6%, and trade in the past two sessions has been dominated by digestion of Fed action so unless the number comes in as a real surprise we should see no action. Another day for the record-books today: the 2, 3, 5, and 7yr yields all hit record lows (2: 0.3118, 3: 0.4304, 5: 1.0148, 7: 1.6869), while spot gold reached yet another all-time high of 1390. Fed-speak to accompany yesterday’s statement starts tomorrow with Plosser, Fisher, Bullard, and Lacker at the Atlanta Fed Conference. Also, lone-dissenter Hoenig is speaking at 9:30 and Ben at 2PM.

I’ll watch for you.

Rock the Sleigh

Kirsten O'Farrell — Thu, 28 Oct 2010 15:37:01 +0000

Expectations for QE2 have eased. Markets act out on this notion by unwinding risk; i.e. equities sell off and the dollar rises. At first, when speculation of the possibility of more QE began, prompted by the Fed’s announcement to reinvest maturing MBS, markets reacted as if to say we must be in worse shape than we thought. But after digestion of such a notion, the opposite reaction occurred. The new interpretation makes less sense logically. A sell-off in the dollar, as QE means printing more money: logical. Support for treasury prices, as it means the Fed will be buying them: questionable if thought through, but initially logical. But a positive reaction from equities to every piece of negative data because it increased the likelihood of more QE? I’m not sure if that’s logical but that’s what happened. Somehow, more potential for the Fed to act was a security blanket. The interpretation of a finger on the Fed’s trigger shifted to optimism that if we are that bad off the Fed can fix it by printing money.
Well, now a new translation is sinking in. A logical one. Printing money might not do anything but add to an imminent inflation problem and make it even harder to unwind the massive load already on the Fed’s balance sheet. That, coupled with the fact that the Fed may not buy anywhere near what was originally thought is causing those QE-positive trades to come off.

The Fed wants to create inflation. We get that. Investors get that, as illustrated by the negatively yielding 5yr TIPS auction. But skepticism about the effectiveness of more QE aside, the fear of rampant inflation is becoming more real. Ok so maybe expectations for QE2 were over-cooked, the Fed has done its job by creating the behavior that surrounds inflation expectations, and subduing expectations was intentional. For what it’s worth, I think the markets will be disappointed by the result if any number is factored in. The Fed doesn’t give definitive, pigeonholing statements. Why would they start now? The same goes for defining a numerical inflation goal in the statement. It’s more likely that what Richmond Fed President Lacker said about the inflation goal will be the caution used for sending a message about treasury buying projections. “I’m not sure if that’s the appropriate place for it, just because you want an objective to be viewed as chiseled in stone and not frequently changed.” Robin Harding suggested in yesterday’s FT, “the immediate issue for the Fed is whether to signal a bias toward easing,” but, “underlying the immediate debate is a much deeper question: what is the Fed trying to achieve with QE2 and therefore how big should it eventually become?” Getting the statement is not going to be like Santa coming to town. We’re not going to unwrap the answers on November 3rd and the sell-off in equities is the realization of that.

The good news is that the elections are the day before. Unlike the Fed statement, they do offer definitive answers, or at least, more realistic expectations. They have infinitely more potential for impact because, with rare exception, we get the answer on that day. No jawboning, no backpedaling, no misinterpretation. The markets want a GOP majority in the House and one in the Senate would be like Christmas. Then attention would shift toward realistic changes by way of pro-growth philosophy. Watching what gets accomplished will be a whole other gift.

Seoul of War

Kirsten O'Farrell — Fri, 22 Oct 2010 17:51:50 +0000

For what it’s worth, Geithner’s political spout out about not pursuing a deliberate policy of devaluing the dollar is bull with QE2 apparently in the pipeline. Formula for not being a target for currency manipulation accusations at the G20 meetings: talk about liking your country’s currency to strengthen, or, raise your interest rate.

The latter is in reference to China’s surprise hike on Tuesday, which drove a nail into the coffin of Wen’s argument that loose monetary policy in developed countries has caused potentially detrimental capital flows into less developed countries. The higher rate encourages increased capital inflows, however, the argument that China’s policies are purely protectionist holds less water.

The former is obviously regarding Geithner’s argument that, in spite of the way it may appear, the US is officially pushing for a stronger currency. Both look like politics at its best. After all, there was a rumor going around late last week of a deal between China and the US that China would allow greater appreciation of the Yuan if the US used less aggressive QE measures. As we talked about a bit last week, letting the dollar appreciate gives the Fed a little more bang for its buck when it does unleash some more QE. But giving the markets the sense that less QE will be used would detract from the effectiveness of the security the potential of it gives the markets. You can derive your own hypothesis from that.

It remains to be seen if G20 finance ministers can come up with any sort of agreement that will do what Geithner suggests, move toward establishing norms on exchange rate policy. See: Geithner to Press G-20 on Exchange Rates . The markets see dollar weakness as a function of QE2, which is seen as a positive for risk assets, namely commodities and equities, and upsetting that balance would send shocks through world markets. So traders wait now for results of the meetings to resume normal activity. See: Traders On Alert as G20 Finance Ministers Meet. For lack of conclusive argument at the moment I will resume discussion surrounding the currency war next week but for now, interestingly, I am seeing more and more of trades such as treasury put buying. That should be a clue. Unfortunately for equity bulls the weak dollar-positive stock-pressured rates trade says that if that trade works it will not be good for equities.

Implied Inflation

Kirsten O'Farrell — Wed, 13 Oct 2010 20:20:59 +0000

Although it’s not necessarily the case that the Fed will unleash some more QE on the economy, the markets took the minutes as confirmation of what it factored in three weeks ago after the last meeting. But what we can’t forget that the meeting was three weeks ago and the next meeting is three weeks away. A lot can change between now and then. The behavior of investors in anticipation of QE and its predicted effects, or in the presence of or absence of fear of deflation is important here. What’s also important to look at is what is factored in, especially to bonds, and how that sways the effectiveness of a move by the Fed if there is to be one.

Market sensitivity has narrowed to rely heavily on policy expectations for cues and the Fed has market psychology on its side, but it could just as easily be against it. Contradictory is the focus of the Fed to be pushing inflation higher if their goal is to push rates down by buying Treasuries. I’ve heard this choice of words and resulting dip in bonds called a head-fake by the Fed to ensure the effectiveness when they do announce.

In the his column yesterday, QE2 Will Have to Encourage Risk Taking, James Mackintosh talks about the self-fulfilling market prophesy that the Fed is arguably creating; “across the board, markets are pricing in a return almost all the way back to normal inflation. In one way, this is self-fulfilling: take away fears of deflation and the changes in behaviour that follow make deflation less likely. Equally, higher commodity prices resulting from QE2’s expected debasement of the dollar create inflation.” Are they actually trying to create inflation or just turn our heads away from the dangers of factoring in deflation?

More QE, a weaker dollar, and looser policy were all ammunition used to take aim in China’s defense of its own monetary policy this weekend at the IMF meeting. Unfortunately, the firm and highly vocal counter-argument set the tone for the meeting and thus it concluded without any sort of resolution.

More unfortunate is that both arguments are right; manipulated exchange rates stand in the way of global recovery and, super-loose monetary policy in the advanced world creates destabilizing capital flows for the emerging companies. As well, the guilt lies with both sides, but neither is willing to budge.

A new money flood resulting from QE2 will cause dollars to be injected into countries whose debt has a worthwhile yield, thus exacerbating the problem less developed countries have.

I’m not saying that based on policymakers’ judgment of the rate of improvement in our economy that QE2 is or isn’t warranted but I do wonder if we’re ready to handle to the side-effects and the consequences if it backfires, i.e. if China starts selling our debt from its balance sheet, or if our own inflation rate starts on a scream higher. On Friday, Bernanke is speaking at the Boston Fed’s Conference on “Revisiting Monetary Policy in a Low-Inflation Environment.” It will be an opportunity for Ben to offer up some clarity.

Gloves Off

Kirsten O'Farrell — Wed, 06 Oct 2010 17:06:17 +0000

There’s a lot of expectation surrounding the International Monetary Fund and World Bank meeting this weekend in Washington. The currency war sparked by global efforts to recover from the Great Recession and its repercussions should be the main discussion as governments around the globe increasingly try to use exchange rates as a domestic boost to growth.

On Monday a direct warning was sent by Charles Dallara, Institute of International Finance managing director, that the world’s leading economies must come to some sort of agreement on a currency pact or face more counter-productive protectionism. He called for a more sophisticated version of the 1985 Plaza Accord to compliment an exchange rate understanding. Tuesday, shortly before the Bank of Japan surprised the world (although we shouldn’t have been surprised) with an interest rate cut to a range of 0.00% to 0.10% from 0.10% and threw quantitative easing on the table, the IMF sent a similar message about using exchange rates to solve domestic problems. Dominique Strauss-Kahn, head of the IMF, warned that, “translated into action such an idea would represent a very serious risk to global recovery…Any such approach would have a negative and very damaging longer-run impact.” The dual warnings encapsulate what should be the topic of foremost concern this weekend as officials from economies around the world convene to discuss measures to be taken to help the climb out of a troubled global economic state. Yesterday, equity markets displayed their raw sensitivity to data and events leading up to the November 3^rd Fed meeting by cheering at the BoJ’s move and then at a better than expected ISM Non-Manufacturing number (53.2 versus expected 52.0). More than just a bright spot, the ISM number had some fortunate timing and proved a theory about the dollar. Good US data leads to optimism and equity bids, putting pressure on the dollar as it equates to the risk trade, or dollar carry while the obvious bad US data puts pressure on the dollar because it raises expectations of further quantitative easing. The BoJ’s announcement of its “comprehensive monetary easing” policy was intended to put pressure on the Yen but at the same time raised expectations of further US QE and sent the dollar south. This was then compounded by the ISM release. Expectations were also helped by some Q&A in the WSJ with Chicago Fed President Evans who said, “We need more accommodation. A lot of people respond that their take on monetary policy depends on the data coming in from here on out. For me, the data have spoken very clearly. As I stared at the forecast even before the August FOMC meeting, I had come to the conclusion that things were very different than what I had been expecting in previous meetings. This is a far grimmer forecast than we ought to have. So yes, I’m in favor of more accommodation.” But there’s still a lot of questions surrounding the seemingly imminent policy change here and what a point Philly Fed President Plosser makes in his opposition to QE2. The Fed has faced much criticism for sending the wrong message. In an interview with the Financial Times he said, “I think that before we can engage [in further QE] we need to be very clear about what it is we’re trying to do, how we’re going to go about doing it, how we’re going to measure whether we’re effective at it or not, and how we’re going to communicate that.” I think the latter is the most important. Along with Evans, George Soros happens to disagree. I wonder what trade he’s got on that favors further QE. Plosser voices concern over further easing By Robin Harding in Washington Published: October 4 2010 06:17 | Last updated: October 4 2010 06:17 America needs stimulus not virtue By George Soros Published: October 4 2010 21:52 | Last updated: October 4 2010 21:52 This morning’s ADP private sector employment numbers disappointed the tape by clocking -39K versus an expected build of 18K but even though it gave equities a breather it was in line with most expectations for the private payroll forecast within Friday’s Non-Farm report as ADP tends to miss by around 76K. Tomorrow we get the Monster Employment index, Weekly Jobless, and Treasury issuance announcements. Then at 1:30 Hoenig speaks. I’m looking forward to hearing what the lone dissenter has to say. He kind of has Plosser on his side now. At this point it doesn’t seem like Friday’s employment data, or any sort of agreement discussed at the IMF meeting are going to influence whether or not we will see more QE but I’m curious to see if expectations change. The question is as much how much and when as it is what message is sent. Now with the currency war acknowledged, while we have been demonizing everyone else for intentionally devaluing their currencies, we have to make sure we don’t come across as hypocritical, lest our message with more QE look like a tired effort to say “In your face, Yen and Renminbi!” Then we can surely expect China to pull the trigger and start diluting our treasury prices with their holdings, pushing yields the Fed has worked so hard to push down back up. Sure enough, there are headlines just out about Wen warning that forced revaluation of the renminbi could be disaster for the world. Get ready for more of them fightin’ words.

Siberian Dollar

Kirsten O'Farrell — Thu, 30 Sep 2010 15:13:57 +0000

A cold wind blew in China’s direction from the US House of Representatives last night. The House voted yesterday on a bill put forth by the Ways and Means Committee which dubbed China a “currency manipulator.” The name-calling is not new but the guts to say it out loud is. The watered down version, called the Ryan Murphy bill, that passed the House vote is legislation that would allow the US to impose tariffs on imports based on estimates of currency undervaluation. Its intention is to punish China for not allowing its currency to rise in accordance with natural market forces, although the language is broad enough to apply to other Asian countries.

So, in the currency markets we have a brewing an international war, as pointed out by Brazilian PM, Guido Mantega. It’s a race to devalue, which not everyone can win at once because currencies, unlike any other asset, are valued solely based on each other, making it impossible for them all to fall. They affect other asset prices for sure but as a market they stand alone.

The problems caused for the US export and manufacturing businesses by China’s currency manipulation are not new but they are exacerbated by movements to do the same by Taiwan, Brazil, South Korea, and most importantly, Japan, who recently dumped Yen to buy $20B. The chatter surrounding the Murphy bill today is all about how we went about this in the wrong way and this will cause trade tensions and ultimately hurt ourselves by making Chinese goods more expensive. The other side of the coin, however, is that we kind of don’t really have a choice. If other central banks are now coming to the table to fight we have to take aim at the perp who does the most harm.

The bill must still pass through the Senate, which is not likely to happen before mid-terms and the market is not pricing in trade tensions but if it does pass and the penalties come to fruition, there is the possibility we can at least expect some form of retaliation by China. This usually entails some kind of threat to change the balance sheet levels of dollar-denominated assets.

The US, Japan, and GB are likely to orchestrate more direct currency intervention or we will see the value of our currencies depressed as a result of further quantitative easing. If other central banks take either of these tacts it increases the likelihood of the latter happening in the US at the next meeting.

The brewing concern about currency manipulation is likely to me the main topic at the IMF/World Bank Fall meeting next weekend. The G7/G20 finance ministers and central bankers will have an opportunity to meet there. This comes after the Bank of Japan meets on Monday and Tuesday, the Bank of England meets on Wednesday and Thursday, and the ECB makes post-meeting comments on Thursday as well.

The G-20 Summit is in Korea November 11-12. We’ll see if they come to some sort of compromise.

We have a big week for data coming up. Non-Farm Payrolls, for which we got the last batch of September data this morning (Initial unemployment claims dropped 16K to 453K, a larger than expected drop), are the most watched but leading up to Friday’s number we have other employment-related data, ISM Non-Manufacturing Index, Factory Orders, and Wholesale Inventories, post-employment. Sorry no charts today. Stay tuned.

WSJ: Blaming China Won’t Help the Economy

By ANATOLE KALETSKY

Published: September 26, 2010

http://www.nytimes.com/2010/09/27/opinion/27kaletsky.html?_r=1&scp=1&sq=blaming%20china&st=cse

FT: Currency wars

By James Mackintosh

Published: September 28 2010 22:43 | Last updated: September 28 2010 22:43

http://www.ft.com/cms/s/0/7610475e-cb45-11df-95c0-00144feab49a.html

FT: Intervention: The genie has escaped from the bottle

By Peter Garnham

Published: September 27 2010 17:38 | Last updated: September 27 2010 17:38

http://www.ft.com/cms/s/0/50ea3302-c9c6-11df-b3d6-00144feab49a.html

The Great Hesitation

Kirsten O'Farrell — Wed, 22 Sep 2010 02:04:34 +0000

We have to accept the bad that goes along with the good concerning recovery. Earlier this week the National Bureau of Economic Research declared the end of the recession we are recovering from now to be June of 2009, totaling 18 months, the longest postwar recession to date. But just because the recession was “over” doesn’t mean the struggling was over. I recently heard the recovery since called the “Great Disappointment” because the economists who said recovery would be slow and painful were proven right by, among other things, recovery of output levels, or GDP. Output took only three quarters to exceed its most recent peak after both 16-month postwar recessions, 73-75 and 81-82, while after four quarters of recovery this time around output is still 1.3% below 2007 levels.

That leads me to the next point. Recovery is not happening at the rate Fed members would like, at least that’s the interpretation we are supposed to get from yesterday’s FOMC statement. I say “supposed to” because the Fed knows what reaction it will signal with its carefully worded statements. We haven’t forgotten that Bernanke and Co. admittedly sent the wrong message in the last statement with the announcement of reinvestment of maturing MBS, and then reversed the message with his Jackson Hole speech. Regardless, the widely held interpretation of the statement is that the Fed is transitioning toward a new round of QE and we can all but expect the Fed to add to its balance sheet, barring any significant signs of strength out of upcoming data. This also means the markets will be exceptionally sensitive to data leading up to the November 3^rd meeting. Specifically, the language that signaled this is the change from “employ its policy tools as necessary,” to “prepared to provide additional accommodation” regarding support of economic recovery.

The Fed also changed its mention of levels of inflation in a way that anticipates easing by noting that already low inflation measures “are currently at levels somewhat below those the Committee judges most consistent” with its mandate and that “inflation is likely to remain subdued for some time.” In this regard some believe the Fed has already done too much, as illustrated by skyrocketing gold, not to mention record highs in other commodities. Cotton is at a 15 year high and Corn at a 2 year high, to name a few that feed into food-related inflation numbers. Without direct mention of inflation, the Organisation for Economic Co-Operation and Development alludes to action already taken as being a hindrance to the recovery lost in the recession with this statement; “It is likely that the financial crisis and response have raised the cost of capital for the foreseeable future and thus lowered potential output.” Even if inflation levels are not in a desirable range right now, doesn’t adding to the balance sheet and printing more money add to the imminent inflation problem we are seeing signs of already? Correct me if I’m wrong. A little inflation is good but the intention is to ignite the economy with inflation as a bi-product. Not the inverse. More easing seems a more than a little redundant.

A while back I heard some chatter about the how the Fed might not act at the November 3^rd meeting because it’s the day after elections and that would be too much of a shock to the markets. They don’t seem to be concerning themselves with this timing factor but it might prove to be the explanation if nothing is done at the next meeting. I have my suspicions that the administration pressures this easing bias because not enough jobs have been created (has anyone pointed that out yet or is it too far out there?) but I’m drooling to see how the markets react to the elections. Having a Fed meeting the next day might put a damper on that, however. Concerning the effect of further quantitative easing on the Fed’s balance sheet and consequently its ability to act versus restrained growth, it’s a question of what’s worse. And to that I don’t have the answer.

I’ll leave you with charts of the Fed’s balance sheet and of Non-Farm payrolls versus NBER Recession Dating courtesy of SM Research.

US takes stock of the ‘Great Recession’

By Robin Harding in Washington

Published: September 20 2010 20:50 | Last updated: September 20 2010 20:50

http://www.ft.com/cms/s/0/e1fea3ce-c4ed-11df-9134-00144feab49a.html

Destroying King Dollar Is Not the Solution

Published: Wednesday, 22 Sep 2010 | 4:40 PM ET By: Larry Kudlow

http://www.cnbc.com/id/39313137

To Everything, Turn

Kirsten O'Farrell — Wed, 15 Sep 2010 02:03:12 +0000

In what is historically the worst month for stocks, equity indexes are putting on a good show. So far for the month of September, the Dow is up 5% and the S&P, 6%. But there’s some noise beneath the surface. Of the many factors at work here, technical and fundamental, two could inflict the most influence, or at least put us on shaky ground: Fed action and mid-term elections. Yesterday’s price action means markets are starting to realize this, having been positive for most of the session and then ending up right back where they started. Uncertainty is back.

In the period between the last Fed meeting on August 10^th, until Bernanke’s Jackson Hole speech on August 27^th, stocks fell by 6.5%. This was a direct result of digestion of the announcement to reinvest maturing mortgage-backed securities to mean that the economy was in worse shape than we thought and needed more help. It was an invitation to speculate on how much more and what kind of further quantitative easing might come from the Fed. Admittedly, the move sent the wrong message, which Fed members had feared might happen. The Jackson Hole speech did damage control as did the release of minutes from the meeting and since then stocks have rallied by over 5% and bond yields have stabilized somewhat. Based on that, and further positive economic releases, I didn’t think further QE was on the table, at least not unless “the outlook were to deteriorate significantly,” but there have been several analyst calls for renewed proactive QE and lower rates. A Bloomberg article released Monday has Goldman and Pimco forecasting that the Fed will resume easing by the end of the year. Some think the possibility is already baked in, in Eisenhower era low yields. I strongly disagree that this is a possibility and I heard someone call this the “nuclear option.” It will not help the job market, nor will it help the housing market, the thorns in the side of recovery. What it will do is inject fear into the markets and diminish Fed effectiveness, as illustrated by the result of the last meeting. That being said, the options on the table if they were to take further action are worth noting because of each one’s effect on the markets. They are purchasing additional longer-term securities, altering the Committee language in regard to the extended period, and lowering the interest paid on excess reserves. The meeting is on September 21^st. More to come leading up to the meeting.

My other favorite market churner is mid-term election. All over the news today is the number of upsets within party lines. People want change on the local level and on the federal level that will be reflected exponentially. The push is towards more business-friendly and market-friendly policies including the extension of tax-cuts and increased incentives for business spending. As a result we saw more winners come out of so-called “extremist” ideals. I will go deeper into this issue and its effect on the markets in days to come. However, allow me to point out another good point made by James Mackintosh. “Since 1946, equity returns during gridlock have been lower than when the president’s party controls Congress. During gridlock, the S&P 500 has averaged 14.8 per cent in the two years after the new Congress or president takes office, against 19.9 per cent without gridlock. Conversely, bonds have produced much better returns…” However… “The average return when a Democratic president faced gridlock was almost 17 per cent, against less than half that when a Republican faced gridlock. Stopping Dems pushing for big government seems to be good for markets. In fact, though, what matters is not gridlock but whether elections are presidential or midterms. Average returns in the final two years of a president’s term are far higher, at 17.1 per cent, than the 4.8 per cent in the first two. Adjust for this, and there is only a small gap between the parties.”

I dare say if recent election results foreshadow the regime change markets hope for, we aren’t going to need any further quantitative easing. Precocious in this judgment I may be, it’s history that I am basing this on. Timing is everything.

Please respond with your thoughts and questions and stay tuned.

Should markets hope for US gridlock?

By James Mackintosh – Published: September 10 2010 01:51 | Last updated: September 10 2010 01:51

http://www.ft.com/cms/s/0/07cef4f0-bc6a-11df-a42b-00144feab49a.html

Yields Fall to Eisenhower Low in Pimco View of the Fed

By Liz Capo McCormick - Sep 13, 2010 1:41 PM ET

http://www.bloomberg.com/news/2010-09-12/treasury-yields-decline-to-eisenhower-low-in-pimco-bofa-view-of-fed-easing.html