A Generation of Stagnation; Retirement Walks the Plank

We are now looking at a generation of stagnation.  The recovery from the 2008 financial crisis still wobbles like a drunk.  Even though we now have full employment, wages barely keep up with inflation (if at all).  And recent statistics indicate that inflation is growing as fast as a parched lawn.

Regardless of what this Federal Reserve official or that says, the central bank will raise rates as often as humans walk on Mars.  If you're wondering when rates will return to historical norms, the answer is never.  At least, this is the only rational assumption you can make.  With Asia's growth slowing, Europe's growth nonexistent, South America in free fall, Russia going negative in numerous ways, and the Middle East becoming more unstable with each passing day, and no drivers of growth in America except the Fed money printing presses running 24/7, the only future forecast that seems sensible is to expect stagnation for--well, the rest of your life.

With stagnation instead of brisk economic growth, the government's ability to support retirees will be limited.  While Social Security and Medicare won't disappear, they will likely be parsimonious.  If you drop your porridge bowl, they won't refill it.  And pension fund and personal investment returns are being decimated by low interest rates on bonds and bank accounts.  Your retirement is starting to walk the plank.  What to do, then, about your future?

Spend less, save more.  This is a no brainer.  It's not what the Fed wants, because hesitant consumer demand constrains economic growth.  But the Fed be damned.  Your long term well-being requires the thriftiness of Ben Franklin, and if that results in lower economic growth that makes the Fed look bad, well who cares?  (Or, you can substitute more lively terminology if you wish).  With interest rates so low, you can't use the financial magic of compounding to build much of a retirement (see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html). You have to set aside more principal, and hope that the few crumbs of interest income you get will elevate your retirement diet above dog food.

Put some money in stocks.  The inequality of wealth in America has increased because the Fed's easy money policies tend to inflate asset values.  Since the rich own most assets, their wealth  has increased disproportionately from central bank policies.  Realistically, with stagnant wages and a Republican controlled Congress, you can't expect the inequality of wealth to diminish.  (Maybe things would be different if Bernie Sanders is elected President, but both the Democratic and Republican establishments are using all their smoke-filled back room influence and power to prevent that.)  So you might as well join 'em if you can't beat 'em.  Owning stocks can be gut wrenching in times of market turmoil.  But so is a retirement spent eating dog food.  Learn to live with the market's turbulence, and collect the rates of return that the 1% are getting from equities.

Work longer.  This increases your lifetime earnings, which allows you to save more and build up your Social Security benefits.  If you're lucky enough to have a pension, it will likely increase your pension benefits.  Okay, so working longer means a shorter retirement.  But, like we said, retirement is walking the plank.  Just try to avoid having to live in a cardboard box on the sidewalk with a couple of cans of cat food in your raggedy backpack.

Avoid debt.  You can't go bankrupt if you don't borrow.  If you do borrow, some of your future income will go to banks and other lenders in the form of interest payments, instead of enhancing your future lifestyle.  Granted, you may need to borrow for big ticket items like college, cars and a house.  But otherwise, avoid debt.  And pay down the debt you have as you approach retirement.  Especially, lose the mortgage.  Financial advisers may tell you it's okay to have a mortgage in retirement.  But guess what?  If you have a mortgage, that means you may have more financial assets to invest in ways that pay fees and commissions to the financial advisers.  Meanwhile, you have to pay interest on the mortgage debt.  Who's better off?

For more on ways to yank your retirement back off the plank, read http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html, http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html, and http://blogger.uncleleosden.com/2011/01/hope-for-financially-lost.html.  Good luck.

Do the Financial Markets Regulate the Fed?

When the Federal Reserve decided last week to hold short term interest rates at zero, the stock market's reaction was to drop.  Even though easy money has been a shot of glucose for stocks since the 2007-08 financial crisis, the market seemed to be saying that there can be too much of a good thing.

Yesterday, Fed Chair Janet Yellen stated her view that rates should rise sometime this year.  The market reacted positively, even though rising interest rates logically should push stock prices down (since fixed rate investments that compete with stocks would offer higher yields than before).

The implication is that the market is leading the Fed.  The market wanted rates to rise, and when they didn't, the market pouted.  That may have prompted Chair Yellen to make more noise about rates rising, and then the market cooed with approval.

Why would the market want rates to rise when conventional wisdom holds that stocks should love easy money?  Maybe it's because the stock market absorbs information from a variety of inputs, both short and long term.  Easy money is positive in the short run, but can be corrosive in the long run.  Accommodative policy by the Fed and other central banks has continued for almost 8 years now, and is distorting asset values and relationships to the point where the social contract may be changing.  With interest rates so low, the ability of pension funds, insurance companies and other asset managers to provide pension and annuity income is becoming impaired.  (For more, see http://blogger.uncleleosden.com/2015/04/is-federal-reserve-wrecking-retirement.html.)  When private parties can no longer provide retirement income, greater responsibility falls on the government.  Social Security and similar programs become more essential.  If these programs suffer from fiscal imbalance, taxpayers become more burdened.  We can't toss retired and disabled people into the gutter, but who besides taxpayers can cover their needs?

Another change in the social contract is that easy money favors the wealthy.  Low interest rates have pushed up the value of risk assets--stocks, real estate, commodities and so on.  The distribution of income and wealth have become more skewed in favor of those who need the money the least.  Such growing inequality makes it more difficult to attain social and political compromises and consensus.  A resentful and angry society may lack the optimism and initiative for investment and risk-taking that would foster strong economic growth.  (Note that jaded, cynical Europe is hardly a hotbed of innovation.)

The voices that are heard at the Fed tend to be those of elites--Wall Street executives, influential academics, power players like IMF Managing Director Christine Lagarde.  A lot of these voices have advocated keeping interest rates at zero.  But the accumulated knowledge of many thousands of participants in the real financial world seems to signal that continued distortion of asset values is doing more harm than good.  Maybe the market is regulating the Fed.  And maybe, at least this time, that's a good thing.

Is the Federal Reserve Wrecking Retirement?

We're now in the 7th year of Federal Reserve induced ultra low interest rates.  The Fed has kept short term rates at zero (actually negative, once you take inflation into account) through monetary policy.  Long term rates fell as well, especially after the Fed devoted years to quantitative easing (i.e., purchasing bonds in the open market).  Those people old-fashioned enough to actually save money have been bedeviled by the near-absence of interest income.  While some have been desperate enough to gamble with risky investments like junk bonds in order to generate more income, many and perhaps most have simply tightened their belts and spent less.  After all, if you're not getting any interest income, the last thing you want to do is spend down your principal.  That's like eating the seed corn--there will be no more harvests once the seed corn is gone.

Insidiously, the years-long pandemic of low long term interest rates has undermined retirements.  Pension funds, insurance companies and other persons and entities trying to provide for America's retirees have historically depended on long term bonds to provide a stable source of predictable income.  Pensions funds, insurance companies offering annuities, and other providers of retirement income tend to have relatively predictable obligations (i.e., the payouts they must make to current and future retirees), and look for predictable sources of funding to ensure that they can meet their obligations.  U.S. Treasury securities, agency bonds and high quality corporates were the bread and butter of retirement funding.  But these same stable long term investments have since the 2008 financial crisis been paying lower and lower interest rates. It's getting harder and harder to finance defined benefits.  While pension funds, insurance companies, municipalities and the like have sometimes turned to stocks and alternative investments, the volatility of these alternatives makes them a poor substitute for the plain vanilla fixed-rate, meat-and-potatoes high quality bond.

Of course, pension providers could contribute more funding to pension plans to make up for the shortfall in interest income.  But how many corporations, states and municipalities do you see leading the charge to put extra profits or taxpayer dollars into pension plans?  Many seem to be looking for spots on the increasing crowded sides of the road to dump current and future pensioners.

Corporations have curtailed and terminated defined benefit pension plans.  States and municipalities are in the process of doing the same.  Multi-employer pension plans are going belly up like fish in a toxic waste spill.  Soon, almost all of America's workers will be left with largely self-funded defined-contribution retirement plans, like the 401(k), or with self-funded retirements using IRAs.  Experience teaches that self-funded retirements are usually not as stable or comfortable as retirements funded with defined benefit pensions.  And that's just for the 40% of Americans who have any retirement savings at all.  As for the 60% who have none (as in zero, zilch, nada), the opulence of life on Social Security beckons. 

To be sure, Fed policy isn't the only reason why interest rates are low.  Economic and political instability in many other parts of the world are driving capital into safe dollar-denominated investments.  Low inflation tends to keep interest rates low.  But the Fed, as the single most powerful force in the money markets, has played a crucial role in eradicating high long term rates.

While Wall Street, corporate America, the 1% and many of the unemployed have benefited to varying degrees from the Fed's suppression of positive interest rates, there is, as economics teaches, no free lunch. There are costs to persistently low interest rates, and much of the cost has fallen on those middle and modest income workers who have or hoped for a defined benefit retirement.  Okay, so we already know the wealthy enjoy a heads-we-win, tails-those-little-people-lose advantage.  But we shouldn't buy into the Fed's story that it's creating stability to prevent a Great Depression.  What the Fed has done is transfer losses and instability that could have manifested themselves in another Great Depression, to many of America's current and future retirees, whose golden years may now be more unpredictable and depressed than they had hoped. 

How the Fed Told the Market What It Wanted to Hear

One of the most human things about humans is that they tend to hear what they want.  It's easy to take advantage of this trait. Politicians do it as a matter of course.  Many, and perhaps most, Congressional districts are gerrymandered to favor one party or the other, so that members of Congress can be elected, and then endlessly re-elected, simply for saying what their constituents want to hear.  Our gridlocked government doesn't actually do anything.  We pay members of Congress nice salaries simply to say what we want to hear--and in the final analysis the shame is on us.

Government officials aren't above telling us what we want to hear, either.  The Fed's latest policy statement is a good example.  The word "patient" was removed, indicating that there wouldn't necessarily be much warning of an interest rate hike.  This is hawkish. 

But the statement also tried to make nice-nice with all the skittish investors out there who bet on continued money printing by saying that a rate increase in April is unlikely, and that the timing of future rate increases would be dependent on economic data.  The Fed also continued from the previous statement to say that it anticipated moderate economic growth, lower than average inflation in the near term and a continuation of its practice of re-investing principal payments from its holdings of federal agency and Treasury securities into other agency and Treasury securities (thereby maintaining the size of its balance sheet).  These dovish statements softened expectations for rate hikes in the near future.

The market rallied yesterday (Wednesday, March 18, 2015), with the Dow Jones Industrial Average rising almost 230 points (more than 1%).  Today, the Dow dropped 117 points, or 0.65% (although the Nasdaq rose 0.2%).  What gives?  The market initially read the Fed statement to be dovish and drank deeply of the punch bowl.  But Fed Chair Janet Yellen also has made clear that there are no assurances as to June and a rate increase in June is possible.  The market evident sobered up today and took some money off the table.  The Fed statement didn't change from yesterday to today.  What changed was how the market read the statement.

The Fed is now in the position it wants to be in--it can move rates without giving a lot of notice.  It has much more flexibility to react to changes in economic data.  Investors who are caught leaning the wrong way can't expect a bailout.  We're back to the past, to the Fed of the 1970s, 80s and 90s, which tended to be opaque and liked it that way.  It had room to move.  For example, in 1994, the Fed decided to raise rates, when large swaths of the market didn't expect a rate increase.  Many hedge funds and other investors were seriously discombobulated, but there was no money printing done to make the boo boo go away.  All the losers could do was to reflect on how there's a certain amount of rancid cheese in life and you just have to deal with it.

Now, let the investor beware. 

Dreaming of Higher Interest Rates

Today's employment report, which shows a gain of 295,000 jobs and a lower unemployment level of 5.5%, knocked the wind out of the stock market's sails.  The Dow Jones Industrial Average fell almost 279 points or about 1.5%.  Bonds retreated as well, while the dollar rose.  The new employment data heightens the chances of the Federal Reserve Board raising interest rates as early as June, something that's detrimental to today's rosy asset valuations. 

In the past year, there have been innumerable rumblings from hawks and doves on the Fed about when to raise interest rates and how quickly.  As the economy has improved, the Fed's public signals have morphed from waiting a significant time and being patient, toward saying that their decision on rate increases will be data dependent.  That means rates could increase any time, if the Fed decides that the data warrants an increase.  Fed Chair Janet Yellen is a dove on rate increases, but she also wants to have a free hand without necessarily having to be patient.

There's so much debate and angst over rate increases that the sensible thing for the Fed would be to raise rates a quarter point this summer or fall.  That would give the markets a chance to adjust to a world without zero interest rates, something they haven't experienced in seven years.  After an initial tantrum, the market would probably figure out that 25 basis points is just 25 basis points, not the beginning of a massive depression and the end of civilization as we know it.  Some of the heat in the debate over rate increases would dissipate, and the dialogue could become calmer.  The hawks would have had their way, at least for a first step.  And the doves would realize they don't have much to worry about.

That's because economics would dictate that rates should remain low as long as inflation remains low.  Inflation, even without considering the falling price of petroleum, remains below 2%.  There is no economic justification for rates to rise much.  On or two quarter point rate increases would establish that the Fed is not locked into perpetual pedal-to-the-metal stimulus.  And low inflation rates would give the doves a basis for tightening ever so gently--and patiently.

So, if you're dreaming of higher interest rates, dream on.  When you wake up, you'll find that our low inflation reality means it was just a dream.

Economic Consequences of the Mid-Term Elections

The economic consequences of yesterday's mid-term elections will be zero.  In order to boost the economy, the federal government would have to raise taxes, cut spending or both.  Even though President Obama now faces a majority Republican Senate as well as House, he won't agree to major tax cuts and the Republicans won't agree to major increases in spending.  So the fiscal impact of the mid-term elections will be effectively zero.  With the federal deficit lower than the historical average of 3% of GDP, there's room for fiscal stimulus but no political impetus for it.

Modest spending boosts may come from an increased military role for the U.S. in the Middle East.  Trying to suppress ISIS is becoming a game of whack-a-mole.  And American air power may have to target an al-Qaeda affiliate called the al Nusra front as well.  But such mission creep will be constrained as there is no public support for a resumption of ground warfare by U.S. troops.  The defense budget won't provide major stimulus.

Monetary policy is the only real game in town, and central bankers are the croupiers.  The Fed has just ended quantitative easing in the face of 3% plus growth by the economy, but there's nothing that stands in its way if it wants to fire up the monetary printing press again.  Just the push of a few computer keys, and the QE program is up and running again.  The Japanese central bank has recently placed a lot of QE chips on the table, putting a punch bowl on the table even as the Fed takes one away. 

The newly empowered Republicans in the Senate will probably increase pressure on the Fed to step back from accommodation.  That would be a fool's errand, as there is nothing the Republicans could actually do over the next two years to substitute for the loss of Fed accommodation.  If Republican pressure on the Fed slows the economy to stall speed, look for smashing Democratic victories in the 2016 Presidential and Congressional elections.

Fed Guidance in a Fog

The terrain is getting foggier and foggier for the Federal Reserve.  Most recently, GDP barely grew (at an annual rate of 0.1% for the first quarter of 2014).  But nonfarm employment grew by 288,000 jobs in April, a pretty good pace.  And the unemployment rate dropped to 6.3%.  Not that many Fed Open Market Committee meetings ago, an unemployment level of 6.3% would have been below the point where the Fed's guidance dictated a rise in short term interest rates.  But rising rates would make the stock market pout and sulk.  So the Fed has backed away from firm benchmarks for monetary policy and is electrically sliding its way toward a strictly "data-based" policy.  What does that mean?  Apparently, it means whatever the Fed thinks the data indicates it should do in order to promote full employment. But if the data is becoming less clear, then what?

For more than a decade, the Fed has worked to provide greater transparency.  That's perceived to be a good thing because it tells the financial markets what to expect.  Presumably, investors will make wiser decisions if they better understand the lay of the land.  But transparency also encourages risk-taking.  If you know what the central bank will do, you can layer on more speculative bets because one factor that might blow you up now seems predictable.  This perhaps unintended consequence of transparency tends to lock the Fed into its guidance, and limit its options, because if you do something other than what you say, all the hedge funds, big banks and other speculators might get hosed.  And then the specter of a systemic tummy ache would loom. 

With the data getting murkier as the economy recovery sputters along, the Fed has become less transparent.  Most likely, this isn't accidental, as the Open Market Committee no doubt can see that the data is telling them less and less, and benchmarks don't mean what they used to mean.  The gamblers in the stock markets can't be happy, as the odds have become harder to calculate.  Fed policy now depends on the data, and recent data resembles a pushmi-pullyu.  

The Fed still hums the low interest rate melody even though it doesn't sing the lyrics any more.  That's a pretty good pacifier for the stock market, at least for now.  But with foreign affairs descending into the mosh pit (who wants to bet Vlad the Invader won't strike again?), and the economic recovery constantly shifting back and forth between first and second gears, the data--and consequently the Fed's guidance--will probably get foggier.

When the Market Will Go Down Next

With the stock market having more than doubled since its 2009 low, the question on the table--just about every investor's table--is when will the market turn down?  Recent trading days give us a likely answer.

For the past three trading days, the market dropped sharply as momentum stocks had bad momentum days.  Today, the market rallied briskly when the Federal Reserve released notes of its most recent open market committee meeting, indicating that central bank accommodation is alive and well.  Sweeter words could not have fallen on the market's ears, and stocks rejoiced.

As long as the market has confidence in central banks, there won't be a major downturn.  If the market senses that central banks are losing control, watch out.  Corporate earnings matter for individual stocks.  But central banking is the key to the overall direction of the market. 

Is Financial Inequality Constraining Economic Growth?

Businesses are having trouble raising prices.  (See http://online.wsj.com/news/articles/SB10001424052702303743604579354693061491748.)  Consumers resist price increases and look for cheaper alternatives.  The stagnation of middle class incomes surely plays a large role in keeping downward pressure on prices.  With people becoming wary of debt, the decline in the real incomes of the middle class leaves folks with no choice except not to spend money they don't have.

It's become an article of faith among central bankers that a little inflation--in the 2.0 to 2.5% range--promotes economic growth.  And they strive for such a Goldilocks level of inflation.  Whether or not this actually will work isn't clear.  Inflation isn't like the flow of water from a faucet, which can be kept at a desired level while economic growth blossoms.  A slithering rattlesnake, sometimes moving slowly and sometimes moving quickly but always potentially dangerous, is a better analogy for inflation. 

Nevertheless, let's posit for the sake of discussion that Goldilocks inflation can be maintained continuously for long periods of time and that it does indeed give the economy a lively fillip.  The ongoing hollowing out of the middle class stands as a major impediment to the central banks' use of inflation as a stimulus for economic growth.  As income and wealth inequality increases, the middle class--and indeed much of the 99%--will obstinately resist price increases.  Inflation will remain muted and not contribute to growth.

There are plenty of reasons to be concerned about increasing financial inequality--reduced social mobility, decreased social cohesiveness, rising extremism (especially noticeable in Europe), and so on.  We can add to the list that an increasingly plutocratic society may constrain the economy's ability to grow.  And that's not good for anyone.

Emerging Markets: Another Asset Bubble Popping

The emerging markets asset bubble is popping.  Financial markets in China, Brazil, Turkey, Russia, and India have been falling, with no end in sight.  Commodities prices have declined.  And the major stock markets--in Japan, Europe and the U.S.--have been dragged down in consequence.  All because the Fed began to reduce its quantitative easing program.

We've been here before.  Fed easy money policies contributed to the tech stock craze of the late 1990s and the real estate and mortgage bubbles of the 2000s.  Those earlier bubbles popped when the Fed began to withdraw accommodation.  You have to wonder whether the Fed will ever learn:  long periods of accommodative policies inevitably create asset bubbles somewhere, and when the accommodation is reduced, the bubble will pop.  Painfully, since there is no other way for an asset bubble to pop. 

When tech stocks, and then real estate and mortgage markets, crashed, recession and unemployment followed.  The results included, among other things, higher and higher levels of unemployment and greater inequality of income and wealth over the past 15 years.  When the Fed repeatedly uses its very blunt monetary weaponry to combat economic slowdowns, the rich get richer and everyone else stagnates or declines. 

What will the Fed do in response to the emerging markets downturn?  Initially, nothing.  It will hope that the positive momentum that has emerged in the U.S. and to a limited degree, in Europe, will be enough to maintain overall global economic equanimity.  But if the decline extends for several more months (particularly in major stock markets), expect the Fed to rethink its stance and get the monetary printing presses revved up again.  As we have discussed before (see http://blogger.uncleleosden.com/2014/01/expect-nothing-from-government-in-2014.html), fiscal policy will be darn near nonexistent this year.  Fed easy money policy is the only way for the federal government to combat economic distress.  And even if more money printing means yet another asset bubble a few years down the line, and more income and wealth inequality, the only choices nevertheless remain easy money or easy money.  The Fed's policies are the only game in town.

One might lament that the Fed never seems to learn that too much accommodation leads to yet another asset bubble that pops, causing distress and dislocation that leads to more accommodation, which only continues the cycle.  But the problem is the Fed has little choice.  Congress and the White House mostly stare at mirrors and ask who is the fairest of all.  The business community waits for the federal government to stimulate the economy, reduce its risks and heighten the potential for profits.  The Fed personifies moral hazard:  the rest of the world has learned that, when push comes to shove, the Fed will act.  So there's no need for anyone else to step out front and center and take the lead. 

How do we break this vicious cycle?  Well . . . uh . . . there was once a time--long, long ago--when the private sector would lead the way out of recessions.  Businesses would start to expand, banks would start to lend, investors would start to take risks.  But how likely is that to happen now? 

Why the Economy Could Grow: the Peace Dividend

Contrary to the expectations of many economists and financial market professionals, the U.S. economy seems to be growing reasonably well.  In the third quarter of 2013, growth was 4.1%.  For a mature, industrial economy, a 4.1% rate is good.  The Cassandras among pundits warn that it can't last.  They could be right--but they also could be wrong.

When one looks at what would impel further growth, many of the usual suspects don't seem to be helping much.  Business investment is tepid.  Income growth in the aggregate is even more tepid.  Only the the top few percent have no fear of the Grinch this Christmas.  The federal government is reducing its spending growth--primarily due to sequestration, but even the new budget deal doesn't offer major spending increases.  U.S. exports have been an economic bright spot the last few years, but America isn't an export driven nation and exports can't turn the economy around by themselves.

What, then, could be producing the growth?  The Federal Reserve's accommodative policies no doubt play a role, although much of the case for reducing quantitative easing is that its marginal impact is diminishing, and very possibly evaporating.  The Fed hasn't done anything lately to produce a growth spurt.  Its primary role has been to keep a thumb in the dike until other forces cause the economy to perk up.

But one factor to bear in mind is that America may be starting to enjoy a peace dividend.  The end of major wars is almost always followed by a period of prosperity.  The Civil War was followed by the rapid growth of the Gilded Age.  World War I was followed by the Roaring Twenties.  World War II was followed by decades of prosperity.  And the conclusion of the Cold War in 1990 was followed by the prosperity of the 1990s.  Only the end of the Vietnam War wasn't followed by a growth spurt, and that might well be attributable to the oil price shocks administered by OPEC, which transferred a great deal of wealth to oil producers and away from the consumers who comprise two-thirds of the U.S. economy.

Even though America remains embroiled in seemingly never-ending conflict, we have a peace dividend in the offing.  The war in Iraq is over.  The war in Afghanistan is winding down.  Although U.S. military and security personnel continue to confront challenges in the Middle East, Africa, Asia and Latin America, none of them involve the expenditure of hundreds of billions of dollars, as did the recent Iraq and Afghan wars.  Large amounts of America's wealth that were being spent on weapons and fighting overseas can now be shelled out for double bacon cheeseburgers, big screen TVs, three-quarter ton pickup trucks, smart phones, Legos sets, kitchen re-modelings, really big cups of soda in New York City, vacuous tattoos, frisbees, pre-mixed cocktails, trips to Graceland, and doggie pedicures.  And a lot of other stuff as well.  Giving peace a chance could be the best federal economic policy of the times.  Even though there surely will be ups and downs in the economy in the coming years, the peace dividend offers a powerful reason to hope for the best.

Beginning the Taper: What Fed Policy Change?

The Federal Reserve announced today that it will begin to taper its purchases of Treasury securities and mortgage-backed securities.  Starting in January, it will purchase each month $40 billion of Treasuries and $35 billion of mortgage-backs, instead of $45 billion and $40 billion, respectively.  A $10 billion drop from $85 billion per month. Whoop-de-do.  That's barely a drop in the bucket.  Yet, after the announcement, the Dow Jones Industrial Average jumped almost 300 points.  A 1.84% increase in the Dow because of a reduction in central bank accommodation?  Financial news stories attributed the stock market rise to a belief that the Fed was signalling that the economy was improving faster than expected.  But there's a much simpler explanation for the exuberance in stocks.

The Fed said that it was likely to keep short term interest rates at zero for "well past" the time when unemployment fell below 6.5%, its previously announced benchmark for starting to raise short term rates.  This is a significant change from previous statements.  It means that the Fed will keep short term rates at zero for a really long time, and it's not saying how long.  Could be forever, since the Fed didn't announce a new unemployment benchmark for raising rates. 

The promise of ultra cheap money indefinitely is to stocks like pouring gasoline onto a fire--instant exuberance.  What the Fed did today was give back with the right hand what it took with the left, and then some.  It's fair to say that the Fed increased net central bank intervention today.  The sharp jump in stocks is consistent with that view.  The relatively minor change in bonds is as well.

But are we surprised?  Did we really think the Fed was going to step out of the picture in a meaningful way?  American businesses and investors have become addicted to heavy doses of monetary methadone from the central bank.  If the Fed began to actually step back, the market would have tanked. 

What happened today is the Fed switched from wearing a blue tie to a paisley tie.  But the change was cosmetic, and net result was more Fed accommodation.  Oh, well. Plus ca change, plus c'est la meme chose.

Are We Stuck With a Powerless Government?

Despite its image as an overbearing ogre, the federal government may be largely powerless these days.  The President has managed to undercut himself with an astonishingly bad non-launch of the federal health insurance exchange.  Is there anyone in his administration with executive or management ability?  Could anyone in his administration succeed as evening shift supervisor at the local McDonald's? 

On the foreign policy front, the President managed to set his foot downrange and pull the trigger over Syria's use of poison gas.  Only an embarrassing intervention by Russia prevented the President from a real morass of a morass.  Now, the administration touts a deal with Iran to freeze its nuclear program, even though it can continue to enrich uranium to the 5% level.  Not very frozen, but perhaps global warming is having an impact.  One wonders whether this deal with Iran is a sign of strength or weakness on the part of the President.

Meanwhile, over on Capitol Hill, Congress remains essentially non-functional.  The Democratically controlled Senate was able to approve the appointment of a few judges by changing its rules, although scowling Republicans made many dire and threatening predictions that the Dems would be sorry for doing this.  Nothing like a love fest to make folks feel collegial.  As for the federal budget and the debt ceiling, they aren't likely to trigger new crises, but will be resolved by kicking the can down the road.

The only institution that seems to be doing anything is the Federal Reserve.  And even it may be losing some of its mojo.  The most recently released minutes of the Open Market Committee meeting in October have been interpreted to mean that the Fed may be thinking about pulling back soon on quantitative easing.  Antacid sales on Wall Street have jumped.  If the efficacy of Fed money printing is diminishing, we may find ourselves in a public policy Sahara with very few water holes.

A powerful government can be scary.  A powerless one can be scarier.  The problem is this isn't a horror movie and we can't get up and leave the theater if we don't like the show.

How the Federal Reserve Defies the Laws of Economics

For an agency run by economists, the Fed seems non-economic.  Its quantitative easing program--now snarfing up bonds at the rate of $85 billion a month--defies one of the basic premises of economics:  the concept of scarcity.  Scarcity is crucial to establishing price.  If something is available in infinite amounts, it has to be priced for free because there's no limit to supply.  Scarcity acts as a constraint, forcing prices up as demand increases.  Price increases in turn compel actors in the market to think and rethink the utility of the thing that's getting costlier, and adjust their use of it.

The problem with the Fed's QE program is that it's paid for with printed money.  In other words, to get the $85 billion it needs each month, the Fed simply makes a few electronic entries into its computer system and, voila, money blossoms.  There is no scarcity.  The Fed doesn't have to get the money from anywhere.  Unlike taxes or borrowings, no one else has less money when the Fed prints some. 

In times past, when central banks pulled such financial alchemy, inflation would flare.  By reducing the value of the currency, buying power would become scarcer and discipline would be imposed.

But today, there is very little inflation--and, indeed, central banks seem to want more.  Thus, there are no constraints on money printing.  And, by all indications, the Fed governors whose voices count intend to keep the printing presses rolling.

Numerous skeptical observers haven't been able to complete the journey to Wonderland and believe that there will be no cost to all this.  And the truth may be that there has been and will be costs.  At the first hints of tapering earlier this year, a number of emerging markets began tanking and some have tanked hard.  Real estate sales have slowed dramatically as longer term interest rates have risen and the real estate recovery may have stalled out.  Gold and silver have fallen sharply, and other commodities prices have eased back. 

The Fed seems to have not really noticed that monetary policy now affects asset values more than consumer prices.  The tech stock boom and bust, the real estate and mortgage boom and bust, and the 2008 financial crisis can all be traced in part back to very generous Fed easy credit policies.  Central banks may be unable to foster inflation, perhaps for reasons that aren't fully understood yet.  But they can foster asset bubbles, and that's a strong reason for easing out of the QE business.  The last thing we need is to again have more government sponsored asset bubbles.

How Do You Invest in a Market That's Fearful and Greedy?

To paraphrase Warren Buffett's aphorism about investing, be greedy when others are fearful and fearful when others are greedy.  In other words, buy low and sell high.

But what do you do when the market is beset by fear and greed?  Market indexes rise to new heights almost every day.  But many investors are increasingly stepping back and hoarding cash.  Indeed, the greedier some get, the more fearful others get. 

There's no established strategy for a pishmi-pullyu market like this.  The fearful, greedy market's bipolar movements defy logic and rationality. 

Much of the market's wackiness comes down to the fact that asset values today are determined as much by government policy as anything else.  We live in the era of the Great Central Bank Accommodation, spiced up with bailouts of one sort or another as ad hoc government policies are slapped together in response to the crisis du jour.  Even though the central banks mutter disquietingly about withdrawing accommodation, they don't really get around to it, because they remain the only show in town when it comes to economic stimulus.  Investors know that government intervention is likely to continue indefinitely, so some invest.  They are also fearful because they know that government support cannot continue forever.  So some hoard cash. 

You can't rationally invest on the political process or government policy.  You can diversify.  That's simply another way of admitting you don't know what's happening or what's going to happen.  Then again, no one does.

The Hidden Inflation

The Federal Reserve assures us that inflation is modest, and can point to measures of inflation it prefers (the PCE price index) or doesn't prefer (the CPI), both of which tend to be modest--in the 2% range or less.  But if you ask a lot of people out in the real world, they'll tell you inflation is worse than that.  And they are right, once you take account of what inflation really means.

The ultimate problem created by inflation comes up when price increases exceed income increases.  If your real income is falling, your standard of living will drop.  That's cause for concern.  When incomes rise faster than price increases, people complain but then dig into their steaks and lobster. 

Incomes today are, in real terms, falling for a lot of people.  Workers on average earn less, net of price inflation: see http://www.bls.gov/news.release/realer.nr0.htm and  http://money.cnn.com/2013/08/15/news/economy/cpi-inflation-wages/index.html.  Median household incomes have fallen since the beginning of the Great Recession: http://www.cnbc.com/id/100980411.  While the fall in household income may in part be due to higher unemployment, it would also reflect the drop in worker earnings. 

Once you look at earnings and household incomes, you can see that inflation in the broader sense isn't so modest.  Since the Great Recession began in 2009, government statistics show that real average weekly pay for full-time workers has fallen 3.5% from 2009 to the second quarter of 2013.  (See http://data.bls.gov/cgi-bin/surveymost.)  The social discord and turmoil that can come from inflation is rooted in falling real incomes, not nominal price increases.  Despite all the statistical soothing the Fed may offer, many Americans today are hurting from this hidden inflation. 

There is little the Fed can do about falling real incomes.  Its monetary tools and bond purchases have little connection to wage and salary levels.  They may boost household income to the extent they promote greater employment.  However, because they significantly reduce interest income for savers, they may also exacerbate the problem of falling incomes. 

As for Congress and the Administration, they're on August recess right now.  And they won't do much about this problem when they get back.  Fights over a budget for the next federal fiscal year (beginning Oct. 1, 2013) and the looming debt ceiling will provide photo ops and Sunday morning talk show invites for the high and the mighty.  The dreariness of ordinary life is likely to get lost in the shuffle.  Talk at the state level about raising the minimum wage may have some impact.  But falling incomes is as much a problem of the middle class as of lower income persons.  Minimum wage laws won't help the middle class very much. 

The overall structure of American society, with its exceedingly generous corporate compensation practices to tax laws favoring the 1% to the decreasing degree of upward social mobility to the astonishing growth in the cost of college educations and more, is thinning out and pushing down the middle class.  No nation has gone on to its greatest days with increased social stratification and top-heavy distribution of wealth.  But nothing is happening right now to change the trend.  This story won't end well.

Why No Great Rotation?

A popular view among market aficionados is that, with bond prices falling while stocks have been rising, money would shift from bonds to stocks.  Stocks and bonds have historically often moved inversely.  When stocks rose, bonds fell, and vice versa. With bonds falling now, it would seem reasonable to expect investors to rotate their money into stocks.  But there has been no rotation.  Why not?

First, for the past five years, we've had a brave new Fed which has manipulated asset values in ways beyond historical experience.  Since early 2009, central bank easy money has helped to spur a stock rally accompanied by a bond rally.  Both asset classes rose simultaneously, instead of moving inversely.  With their traditional relationship out of whack, it is hardly surprising that they don't cha-cha when they're supposed to.  Investors would be understandably suspicious of stocks in a market that is seemingly dependent on the Fed's methadone program, especially when the Fed is talking about easing out of its role as Dr. Feelgood.

Second, the Great Rotation is an investment strategy for the medium to long term.  Today's stock market is dominated by high-speed, computerized trading, where the holding period for stocks is measured in milliseconds.  The long term human investors that might consider rotating greatly have mostly been supplanted, and many have chosen to invest on autopilot, buying index funds and throwing salt over their left shoulders.

So whither the markets?  That's the $64,000 question, and in truth nobody knows the answer.  With both stocks and bonds having enjoyed years-long bull markets, logic and experience, especially recent very painful experience, tell us that when markets can't keep rising indefinitely, they won't.

From the Fed: Short Term Gain, Long Term Pain

As the Fed's ultra low interest rate policies grind on for a fifth year, we can see ever more clearly that there is no such thing as a free lunch, even when it comes to central bank policies.  The benefits of the Fed's low interest rate policies were easy to see at first:  cheap credit, stimulus to housing, a boost to the economy.  The costs didn't seem so great. 

However, by persistently favoring borrowers and heaping mulch on income-seeking investors for five years, the long term costs of the Fed's policies are emerging--and painfully so.  Detroit is in bankruptcy, and other cities teeter on the brink. Corporate defined benefit pension plans are becoming less common than the ivory-billed woodpecker. It's no wonder why.  Pension funds rely on safe long term investments that provide solid returns.  U.S. Treasury notes and bonds used to be crucially important components of pension fund portfolios.  AAA-rated corporates, which would have to pay slightly better than Treasuries, also were favored investments.  But pension plan returns came under stress as the returns on these low-risk investments nosedived.  And pension fund deficiencies, calculated on the basis of long term returns, balloon when returns fall.  Plan sponsors have to increase contributions--sometimes enormously--to keep the plans solvent.  Corporate executives intent on making the big score with their stock options see little upside to signing off on these contributions.  Shrinking cities like Detroit have little ability to make them.  Something has to give, and pensioners seem to be doing a lot of giving these days.  Detroit's problems go well beyond low long term interest rates.  But the city really didn't need the Fed to push it closer to the abyss. 

Neither did a lot of corporate employees whose retirements are less secure after losing their defined benefit pensions or seeing the plans capped.  Most people aren't skilled at managing their finances.  When fewer have defined benefit pensions, more are likely to end up with just Social Security, even if they start retirement with good-sized 401(k) account balances.  When people have fewer or no private resources, cutting benefits from the government becomes political anathema. 

Low interest rates hurt older folks in other ways.  As income from their interest-bearing investments dries up, fear drives them to become serial economizers.  That's a hard habit to break even after rates rise again (assuming they do).  Consumption may be impaired for a long time.  In addition, long term care insurance is getting scarce and expensive.  While poorly conceived estimates by insurers of the cost of care have much to do with that, the inability of insurers to obtain decent, safe returns on investments has added to the problem.  Fewer people are able to afford such policies.  So we have a ticking demographic time bomb, with lots of uninsured elderly likely to need Medicaid in a decade or two or three instead of being able to rely on their own resources.  Low interest rates are beneficial to the federal government's borrowing costs right now, keeping the budget deficit lower.  But positioning a lot of people to need Medicaid in decades to come means we'll have pressure toward an increased deficit in the long term.

 The Fed is taking a page from corporate America:  focus on short term returns at the risk of increasing long term costs.  The great corporate success stories don't follow this plot line.  But there's not much chance the narrative will change.  The Fed's easy money merry-go-round keeps the stock market buoyant.  With mid-term Congressional elections coming up next year, the Obama administration needs to keep the market feeling chipper.  Ultimately, everything in Washington happens for political reasons.  And politics dictates that Janet Yellen, a monetary dove, will be Obama's nominee as the next Chairman of the Fed.

Is the Fed Losing Control?

In the past two weeks, we heard from Chairman Hyde and then Chairman Jekyll.  A couple of weeks ago, Ben Bernanke made allusions to gradually winding down the Fed's bond buying program, called quantitative easing.  Up to this point, the market had perceived the current round of QE as infinite, a perception that Fed had encouraged by placing no time limts on the program, and offering only the vaguest of guidance as to when QE might end.

But two weeks ago Chairman Hyde frowned and cleared his throat, and the bond bulls began running.  In their panic, they gored many an investor who had drank the Kool-aid however reluctantly and bought risk assets like long term Treasuries, corporate bonds and junk bonds.

Within days of Chairman Hyde's hint that the punch bowl might be taken away, the ten year Treasury note was yielding over 2.5% (up from 1.6% in May) and 30-year mortgages popped up about 1% to 4.5%.  Stocks quivered, but didn't belly flop like bonds.  Alarmed, various governors of the Fed and presidents of Federal Reserve Banks chimed in and suggested that the punch bowl wouldn't be withdrawn any time soon.  Stocks perked up, but bonds continued to pout and mortgage rates kept rising. This was emphatically not what the Fed wanted, since the Fed is resorting to its old trick of trying to revive the economy by bubbling up the housing market.  Even though this is what got us into trouble in 2007-08 with the mortgage crisis, the Fed evidently has an abiding faith in its old tricks.

With the housing rally now threatened, Chairman Jekyll spoke up this past Wednesday (July 10) and made nice nice.  The little toddler of a recovery would need propping up for a long time, he said, before he'd expect it to walk on its own--a very, very long time.  He also said he was sending the senior Fed staff out for a late night booze run to stoke up the punch bowl.

Stocks did a cheery little conga and stepped up to new heights.  This might produce a bit of a wealth effect to boost the economy.  But it will be hardly a smidgen, if the bond market doldrums continue. Bonds barely budged after Chairman Jekyll's attempted love fest.  The ten-year Treasury dallied briefly with the 2.53% level, but then went back up to 2.59%.  Mortgage rates continue to cloud the skies over the housing market. 

Is the Fed losing control?  This is really two questions.  What message is the Fed trying to send?  The most recent minutes it released indicate sharp divisions within the Open Market Committee, and the truth may be that a highly mixed message would be the most accurate.  Bernanke's initial statements two weeks ago may have been an attempt to be transparent and let the public know what the Committee really thinks.  But the Fed got what it perceived as an over-reaction from the market, and has been trying to cover its tracks ever since.

But did the Fed get an over-reaction, or an accurate reaction?  The sharp sell-off in bonds and rise in mortgage rates may have reflected the erstwhile rationality of betting on a continuing rally in fixed income.  Central banks worldwide have joined together and danced the most accommodative bunny hop in the history of banking.  Anyone who anticipated a reversion to the mean in the money markets has been just about rendered CIA-style. Much of the flash crash in the bond markets may have been hedge funds and other big players unwinding leveraged positions betting on more booze for the punch bowl.  Now that the Open Market Committee may be going wobbly on the idea of giving a drunk yet another pitcher of Martinis, bond pros evidently are becoming wary of the hair of the dog that just bit them.  If so, the Fed may have lost control of the long end of the yield curve.

If the Fed no longer has a clear message to send, and can't maneuver the long end of the yield curve any more, it may lose control of the economic recovery.  But perhaps it never really had that much control.  Maybe things looked good for a while because people wanted to believe, and the Fed provided the only federal economic policy they could believe in.  With Chairman Bernanke now a short timer, courtesy of President Obama, it's unclear what anyone can believe in.  And that won't be good for the market or the economy.

Regulatory Challenges of the Bond Market

The Great 2013 Bond Market Chain Saw Massacre has probably caused trillions of dollars of losses.  On May 1, 2013, the yield on the U.S. Treasury 10-year note went as low as 1.61%.  Since then, it has vaulted as high as 2.72% and most recently closed at 2.63%.  Such a jump in yields is, as kindergartners would put it, ginormous. 

The inverse math of the bond market would dictate that when yields jump this much this fast, the principal value of bonds will fall painfully and nasty losses will be incurred.  While precise numbers aren't readily available, losses in Treasuries may reach a trillion dollars.  And when you add in corporates, munis, junk bonds, and mortgage-backed securities, the losses could be multiple trillions.

The game of musical losses is now in progress.  Through short positions, derivatives contracts and other hedges, the losses are flowing through to wherever they will end up.  The challenge for regulators is to find out, and quickly, where that end will be.  What must be ascertained is whether the losses are spread out and landing in places where they can be absorbed without too much fuss.  Or whether the losses are concentrated somewhere and could have secondary and tertiary rippling effects (i.e., cause a run on one or a few major financial institution(s)).  Well within living memory (2008, to be exact), sharp losses in the mortgage markets triggered tsunamis in the financial markets that washed over Bear Stearns and Lehman Brothers, and threatened to wipe out AIG, Fannie Mae, Freddie Mac and Merrill Lynch.  Bailouts and regulator-encouraged acquisitions barely prevented an abrupt, loud, low-flow flush of the entire financial system.

Regulators should be proactively trying to pin down where the bond market losses will fall.  Complicating their task is the likelihood of speculators who used leverage to make derivatives bets on a fall in interest rates.  Since there is no prohibition on speculating with derivatives, as opposed to hedging, it is possible (and probable) that some players in the financial markets made such a bet.  That wouldn't be intrinsically different from the bet that John Paulson made in mortgages shortly before the mortgage crisis that sweetened his net worth by billions.  It's also not intrinsically different from the gold bets that John Paulson's gold fund has likely made, which reportedly has sustained losses in excess of 60% (ouch).  Any such speculative bets in the bond markets could exacerbate the game of musical losses, and make the regulators' tasks all the more difficult, since many of the speculators might be trading through entities chartered in off-shore locations that might frustrate U.S. government oversight.  But the Feds will have to do their best, because the alternative would be what happened in 2008, when they waited until things blew up and bailouts were just about the only option.

There's more.  The yield curve has been steepening during the last two months.  The short end remains squashed by the Fed's scorched earth policy on short term interest rates.  But the long end, as we noted above, has been rising meteorically.  This steepening makes attractive a type of carry trade.  It's possible to make a lot of money by borrowing short term and investing long term.  

Fed policy makes this carry trade all the more enticing.  The Fed's intent, as far as it can be discerned from the entrails currently visible, is to begin cutting down on bond purchases (i.e., QE) within months, but to keep short term rates at zero until unemployment reaches 6.5%.  Although employment has been rising, the unemployment rate has been static for several months.  While no one really knows when unemployment will reach 6.5%, it's not uncommon to read predictions of mid-2014 or so for that level to be acheived.  If so, the carry trade could be profitable for a while, especially if the Fed's reduction of bond purchases push long term yields even higher. 

To paraphrase P.T. Barnum, or Mark Twain, or somebody, there's a smarty pants who shows up in the financial markets every minute. Some--and perhaps many-- will surely indulge in this carry trade, most likely on a leveraged basis (because leverage boosts profits, assuming the trade works in your favor).  But if the unemployment rate unexpectedly drops quickly to 6.5%, the partakers of this carry trade might wonder if they aren't living in a septic tank. 

Either way, the regulators have to keep an eye out for the possibility of mounting risks from this sort of carry trade.  It could look like easy money to banks, hedge funds, insurance companies and other important players in the financial markets--after all, with the Federal Reserve at least momentarily anchoring their borrowing costs while pushing up their profits, the government is on their side.  But borrowing short to invest long is the E. coli that has poisoned many a would-be financial marvel.  Regulators need to be watchful not only for bond market losses from risks that have already materialized, but also for the growth of more risk from the changing landscape of the market.