Anti-US protests are engulfing the world like a wildfire (this is truly amazing how fast this is happening and over what really?); from the MENA region, Egypt, Sudan, Yemen, Tunisia, Lebanon, Libya, we can add India , Malaysia, Bangladesh and Indonesia to the tally today, even the US embassy in London saw protestors burning US flags. Truthfully, I am not even sure of the number of countries, but I now it was only 3 or 4 a day or so ago and now every time I look at the news it's somewhere else.
The result, oil which has done well under QE, not as well as it did under the Bush administration though, broke north of $100 a barrel today, oil outperformed gold by 300%. Looking at the overnight futures of gold and oil, it seemed pretty clear the clashes at US embassies and Consulates across muslim nations has caused massive fears of supply disruptions. Beyond the market implications, this is a really scary trend in just how fast this excerpt from a film that was posted on YouTube has engulfed and enraged the muslim world. In fact even right here in the US, threats have closed several campuses as well as a nuclear reactor in Texas. The point is, before any asset purchases have been made and while other risk assets have remained muted today, already painful gas prices may be set for higher prices due to geo-political events, throw QE-3 in and....?
I'm actually going somewhere with this so just hang in there for a bit.
We saw CPI (Consumer Price Inflation) and PPI (Producer Price Index) both move north this week the most we have seen in the last 3 years. Again, these didn't jump 1 day after QE-3 was announced, these are monthly readings.
The market is now pricing in a 3-6 month forward looking
CPI print of 5%, well above the 2% inflation comfort zone. In fact, name this chart...
If you look to the far right, you'll note a spike over the last 24 hours. Can you guess what it is? Gas? Oil? Gold? Palladium? Copper? Nope, that is inflation expectations (Darn I'd love a Bloomberg terminal!) Those are F_E_D inspired.
The F_E_D's dual mandate is price stability and maximum employment, but QE3's open ended nature was tied directly to unemployment, that is the main focus of the F_E_D and the shift away from inflation fighting has been called a "New Era".
Beyond liquidity from thin air, it's not entirely clear to me how the purchase of Agency Mortgage Backed Securities benefits employment, I can see what it might do for housing (although we have already had super low rates and that hasn't done much except in the rental property area), so what does lowering rates another 25 or even 50 basis points accomplish? After 4 easing episodes (QE1, 2, Twist and Twist 2), the F_E_D's policy action has had no meaningful effect on unemployment, if it had I wouldn't be writing this and we wouldn't be talking about this. Our problems are deep-seated structural problems that require more political action or reigning in of it, than easing policy.
In fact, in one o my most prophetic calls (in my opinion), while making a 5-part video series on bubbles and the housing bubble during 2007 before things got really ugly, I predicted that things would get much worse and that at the end of the day, the only way to relieve the pain is to take the medicine. No one wants to take the medicine and it's been extend and pretend, but until we do, this won't end. Those very same words were echoed nearly 5 years later on this very day by some talking head on CNBC.
Employment is a tricky thing when dealing with the BLS, you have to understand how they count or fail to count. There are 6 levels of employment classification from U1-U6, U3 is what we consider to be BLS headline employment data, while the infrequently cited U6 is the same way they counted unemployment during the Great Depression which peaked at 25%, it's a measure of those who are unemployed and those who are under-employed and unemployed (work 1 hour a week and you are employed in U3 even if you need 60 hours to make ends meet). However the real distortion in U3 data is the headline number doesn't take in to account those who have dropped out of the labor force, those who have given up on finding a job-the Labor Force Participation Rate. In Bernanke's press conference he acknowledged that the unemployment rate had come down, but it was misleading as a function of the labor participation rate.
Here's a graphic showing the employment gains and those leaving the workforce since the crisis started, either gave up on looking for a job (think those falling off the 99-week cliff) or those who just decided to retire.
At the bottom we have a 3.415 million gain in employment since the mass lay-offs of the height of the crisis, but there's also been an 8.42 million decline in the labor force, those who have given up on finding a job, this creates distortions in the U3 number as those who have given up are unemployed, but not counted as such; thus if you remove enough people from the participation rate, you could have maximum employment and still have 10 million or more people who would otherwise (in normal times) be unemployed.
This may be rudimentary and redundant for you, but for businesses to hire, they need end demand for goods and services. U.S. ISM (manufacturing) from last week showed us that business inventories are rising, new sales are falling, exports are falling and inflationary pressures are rising in the form of input costs which are reported in the ISM as a sub-index. For manufacturing, inflation is here.
As food and gas take up a larger portion of lower wages, the discretionary money left over to purchase items and create end demand for business obviously falls, as we already know printing money is inflationary. You might recall the survey last week with something like 70+% of respondents saying they can't afford to keep up with new I-gadgets and 55+% resorting to credit to finance such gadgets.
The F_E_D's Bazooka is aimed right at the US consumer, then throw in rising health care (I know a lot about this as it was cheaper to buy my wife a last minute plane ticket to get care in Hungary where she is a resident and has free healthcare than it would be to do all the same things here and my healthcare policy went up 35% for this year and over 100% over the last 4 years) and increasing taxes not too far out along with slowing exports, none of which bodes well for business and end demand. Even those who are employed and able to save will see their buying power diminished, how this stimulates demand for goods and services and leads to higher employment is a mystery, it hasn't worked in the last F_E_D LSAPs (Large Scale Asset Purchase programs) but it sure works well for banks and trading desks.
Even Egan Jones basically made the same case when justifying their downgrade of the US today:
"The increased cost of commodities will pressure profitability of businesses, and increase the costs of consumers thereby reducing consumer purchasing power. Hence, in our opinion QE3 will be detrimental to credit quality for the US."
Another related thought, with business inventories rising and less demand (both confirmed in manufacturing ISM), what happens to inflation in the commodity space? Businesses either don't need it (as evidenced by high and rising inventories and as we saw today lower Capacity Utilization) or they can't afford it. I'm not making this up or proposing theories, official economic data confirms businesses have rising inventories due to lack of sales and as they already have the goods on the shelf, their Capacity Utilization (confirmed in today's PPI) is lower.
Either earnings, which have seen consensus slashed weeks before earnings season for at least the last 3 quarters and still have a high number of companies miss on those reduced expectations, are slashed even more as the margin squeeze becomes more acute or prices are passed on to consumers leading to fewer purchases which is the definition of a vicious circle which fails to stimulate demand and thus employment.
Did you know this week made history? You might think I'm talking about the unprecedented open ended QE3, but I'm not. Before the N.Y. F_E_D's trading desk has purchased 1 MBS, before Bernie has hit Ctrl-P on the massive printer of greenbacks, the national average gas price across the U.S. hit +$4.00, a new all-time record high and the inflationary stuff hasn't even began. Oil pushed over $100, but apparently not on QE-3 as oil out-performed gold today by a 3:1 margin, this was just on the spreading wild-fire of anti-US sentiment that is adding about 4 new countries/incidents a day.
Now before I go further, let me reiterate that my goal in analysis of the markets is to find an edge that makes money, I don't care if it's long (as we have some trades on that are long and a new one mentioned today) or short or a combination of both, which is a possibility as the 10 major economic sectors were performing in 3 distinct groups today, a major shift away from the high market correlation.
At the top: Materials, Energy and Financials; Middle: Industrials, Discretionary and Tech; Bottom: Healthcare, Staples and Utilities (Defensive sectors), but look how correlated they were a day earlier!
In any case, this brings me closer to the point...
Former F_E_D Governor, Kevin Warsh gave an interesting insider's look and perspective in to Bernie's actions (this is a man who served with and knows Bernie quit well and has enormous respect for the man's integrity, he's not one of the very polarized pundits we have seen everywhere the last 2 days). According to Warsh, Bernie's actions were "Panic-like" in times that aren't "Panic-like" (think Lehman); he went on to say Bernie must really be scared about something in the global economy as the exit (which he called a 4-letter word for central bankers) is incredibly more difficult than the entry, insinuating that the eventual cost of moving out of accommodative policy is so high and difficult that you don't enter it lightly without a good reason and in his opinion this looked like panic o the part of the F_E_D.
Warsh adds, "
When asset prices are driven less by fundamentals and more by speeches and policies coming out of Washington, you're taking risks. Risks are highest in the economy when measures of risk are he lowest; and when I look at the VIX at this level and you compare that to the headlines you read every morning, they certainly don't seem in sync, and that's exactly when shocks happen."'
This is the closing VIX today...
The VIX is also known as the "Fear Index" and has an inverse or nearly mirror opposite relationship to the market. The red trendline represents 5 year lows for the VIX which in August the VIX closed below and today for the first time since August, dropped below on an intraday basis. When the VIX is low, complacency among market participants is high, this often leads to market tops as investors are essentially fear-less and have a lack of respect for risk. When the VIX is high, Fear is high and extremes often mark the bottom of a market decline (like Fear induced panic selling or capitulation that ends a downtrend). Warsh is making the point that the F_E_D is acting like they are VERY afraid of something while the market has the lowest level of fear in 5 years.
Finally (these are excerpts from a CNBC interview this morning),
"If they believe the economy and prospects were moving even slowly to a higher path, I don't think they would have decided to be nearly as aggressive."
"I don't like the bang for the buck. I'm not persuaded by the efficacy. I think there are people out there, perhaps even of prevailing opinion in Washington, who think the balance sheet can grow another $3 trillion to $5 trillion to bring us to optimal policy.
The reason I don't believe much of that, who are we buying this debt from? Last year, the Federal Reserve bought 77% of all of the debt that Tim Geithner issued. It doesn't mean that the Federal Government doesn't have an important role to play; but our largest buyers of securities, domestically and overseas, they aren't fooled."'
Now I can't pretend that I know why the F_E_D decided to act so aggressively at this point in time, I do know that today Spanish Yields shot up, not only on the 10 year but on shorter maturities as well. While there can be many reasons for this, the Euro-Group is meeting today (Friday) and tomorrow. One question I wonder about is whether the F_E_D knows something about what's going on over there that they decided they needed to get in front of ? If so, then we should know over the weekend of by Monday.
The other thing that has me intrigued was 2:27 p.m. yesterday when almost every asset class reacted to a question in the Bernake press conference, this was the intraday top for equities (all 4 major averages), gold, Treasuries bottomed, everything reacted.
A +.001% gain from the time of that question.
The question was something like, "If inflation becomes a problem will you reverse course?" The answer was something like, there would be an adjustment to bring inflation back down, but taking in to account the deviation of both the targets (policy and inflation), this was accompanied with a lot of language about "conditionality" and adjusting policy according to conditions which is largely understood to be the unemployment conditions, but also the broader impacts including inflation.
When it is said QE3 is open ended, it is also not explicit like past policies as I outlined last night, for instance QE2 was a specific amount of treasuries to be bought at a specific rate in a specific time frame. In a way, there's some uncertainty in the policy as enunciated and clarified. While most of this is taken with optimism such as additional purchases, there's the other side of the coin and the second mandate-inflation.
I believe the market reacted very touchy and it doesn't appear to be a big deal on the chart above, but when watching the market live as the question and answer came, there was quite a bit of volatility in that price bar, as mentioned, it was the high of the day and we haven't moved very far from it today.
If there's one thing the market does not like, it's uncertainty. The market would rather see a war than the threat of a war, thus the Market maxim, "When the missiles fly, it's time to buy" because the uncertainty of what will happen (Saber rattling) has been resolved. I think also the last few months, last week and specifically this week the inflation scenario has become very clear as well as its detrimental effects on manufacturing, Consumers, etc.
It may be that the promise of QE3 is a little too uncertain as inflation could cause the program to deviate significantly and apparently a large part of QE3 has been priced in. As QE causes inflation and as it is already clear inflation is and was a problem before QE3 was announced, the prospect of additional inflation from dollar debasement may leave QE3 at this point looking like there's no where to go but down as far as the policy itself.
That's opinion based on some hard facts, the actual moment though at 2:27 was in my view, significant; it was a sticky question hitting right on the weak spot in policy and the market reaction was immediate as if it has just realized, "There is a potential threat to the program".
Moving forward, what I'd like to see is an actual pullback or decline, almost any amount (-1%) will do. If heavy accumulation becomes apparent, then it's very likely that QE3 has not been priced in. If we see deepening negative divergences, a pullback with no accumulation and a bump up (1% would probably do) with continued negative divergences, then it's probably safe to look at the policy as priced in and the longer term charts are validated. This isn't to say that very inflationary risk assets shouldn't receive extra attention, they should and will.
Next stop, the Euro-Group meeting; if anything substantial arises tomorrow from the meeting or Sunday, you'll hear about it ASAP.
