Stocks got a boost on a survey released this morning from the National Association for Business Economists (NABE), which lifted its forecast for economic growth over the next year. While it seems they are being overly optimistic in the face of rising unemployment, Stocks continue to seek out reasons to ride higher. Overall, the recent rise in Stocks is easily attributed to the low interest rate environment and constant hints from the Fed that rates will remain low for a long time. Investors are searching for higher returns, and apparently have radically changed their thought process from just a year ago, when it was all about safety, and preservation of capital. But the allure of high returns has investors leveraging with cheap money to push up Stock prices. We’ve all seen this before – markets making large gains on momentum rather than fundamentals – and it usually does not end well.
Our new Fed Friend, St. Louis Federal Reserve Bank President James Bullard said over the weekend that the Fed should keep its Mortgage Backed Security purchase plan active beyond the current end date of March 31, 2010. He stated that keeping the program alive would enable the Fed to do something to react, should the economy take another turn for the worse. With unemployment remaining stubbornly high, and likely to remain so beyond the present end of the MBS purchase program in March 2010 and the Homebuyer Tax Credit in June 2010 – doing something to keep home loan rates from rising sharply would be beneficial to the housing market, and the economy overall. However, there is a long term cost for this, and the effects as well as unintended consequences may be quite significant. It’s getting harder to see what a “real market” looks like, and eventually, we’re going to find out.
Today the market will digest the results of an enormous record $44B 2-year Note auction. This could impact the Bond market, and the record levels of supply keep coming this week, with a huge $42B being auctioned in 5-year Notes tomorrow, followed by $32B in 7-year Notes on Wednesday. So who is buying all this paper…and why? For example, with the yield on the 2-year Note around .75%, where is the attraction? The answer is that “leverage” can make the trade very lucrative. If you can borrow at the Fed Funds Rate like banks can – say at .25% - and invest in 2-year Notes at .75%, there appears to be a .50% arbitrage of “free money”. But Treasuries can be leveraged 10 to 1, or in other words, you need only to put 10% down to buy them. The .50% gain becomes 5% of “free money”. That’s a huge spread in the banking world. But when the Fed Funds Rate starts to move up, it usually does so at a faster rate than the Treasury yields do, making this play less attractive. That would make it both more difficult and more expensive to sell Treasuries, which points to higher rates down the road.
A story to watch very carefully – the Fed’s independence as a Central Bank is under fire. Last Thursday, the House Financial Services Committee voted to undo a 31-year old law that shields Fed interest rate decisions from Congressional auditors. It is yet to be determined how much control or influence Congress will have on the Fed, but if they somehow start to weigh in on monetary decisions...beware. One of the main reasons why the US has never seen runaway inflation is the Fed's ability to act quickly and respond to inflationary threats without political interference. Politicians by nature have a very short term view, and care about polls and immediate public opinion – much like a child who cries for a quick fix of candy, instead of eating vegetables and balanced meals. The candy sure tastes good and quiets the child, but a prolonged diet of candy would have terrible long term impact on the child’s health. Can you imagine what might have happened to inflation if then Fed Chairman Paul Volker had to get Congressional approval to raise the Fed Funds Rate to 20% in the summer of 1981? While the move didn’t taste good temporarily, inflation may not have been choked off as successfully as the Fed was able to do back then – which led to the greatest and longest period of economic prosperity the US has ever had. If decisions had been left up to political influence, the results may have been sweeter in the very short term, but the US would have been far worse off in the long run. There is historical evidence that the loss of independence for a Central Bank leads to rampant and devastating inflation. The great economist Milton Friedman stated, “Inflation is a monetary phenomenon, but hyper-inflation is always and everywhere a political phenomenon.”
And looking forward, there is a real threat of inflation. It may be dormant now and not evident to the masses – but it’s there. And how the Fed responds to this threat will be crucial to the economic health of our country. The thought of politicians with reelection concerns, playing in the midst of monetary policy decisions when inflation comes knocking…it’s enough to keep us up at night.
Some good news on housing...Existing Home Sales were reported at 6.10M, far higher than expectations of 5.70M. The inventory of unsold homes dropped to a 7-month supply, the lowest in 2 1/2 years. Yes, the possible expiration of the Homebuyer Tax Credit certainly influenced the amount of buying in October, but it’s still encouraging to see these improved readings, especially the reduction in inventory levels.
