Market Conditions

Each quarter the Fed releases their assessment of the economy along with their forward looking projections for three years into the future. The reality is, however, is that the Federal Reserve simply cannot verbally state what they really see during each highly publicized meeting as it would roil the markets.   Instead, they use their communications to guide the markets expectations toward reality in the hopes of reducing the risks of market dislocations. The most recent release of the Fed's economic projections on the economy, inflation and unemployment continue to follow the same previous trends of weaker growth, lower inflation and a complete misunderstanding of the real labor market. Reminiscent of the choices of Goldilocks - the reality is that the Fed's estimates for economic growth in 2013 was too hot, employment was too cold and inflation estimates were just about right. The real unspoken concern should be the continued threat of deflation and what actions will be available when the next recession eventually comes.

The FOMC decided to cut the pace of its asset purchases to $75bn/mo, but offset this with a qualitative enhancement to the forward guidance. The Committee's assessment of the economic outlook was somewhat more upbeat. We see today's statement as slightly hawkish relative to expectations. The fact that President Rosengren dissented and President George did not is consistent with that.

The "swap" of $10 billion of asset purchases for a lower employment threshold and lower-rates-for-longer forward guidance knne-jerked stocks dramatically higher (for now). But while that was occurring, the Wall Street Journal's Hon Hilsenrath was busy preparing 712 words in a record-setting 3-minutes to explain how the Fed remains data-dependent... and will remain dovish for longer than previously thought.

There seem to be two camps at Deutsche Bank these days: one, lead by the observant and somewhat contrarian Jim Reid, who recently asked the all important question about 2014 ("what if there is a recession?"), who accurately observed that something "structurally changed" since the great financial crisis (pretty clear what), and who even dared to suggest that the Fed will never taper, especially with the economy so late in the cycle already. And then there is Joe LaVorgna, best known for having a losing track record to Groundhog Phil. It appears that this morning Joey emerged from his lair deep inside 60 Wall, sniffed the cold air, and saw the shadow of a $10 billion taper, which is what he predicts the Fed will do tomorrow.

The Federal Reserve holds its last policy meeting of 2013 in the week ahead. In UBS' view there are four possible surprises that could affect the markets. From the odds of a taper to adjusting forecasts and from forward-guidance communication to the chances of a cut in the IOER, the FOMC meeting in the week ahead presents upside and downside risks to the dollar in the near term; even if UBS believes the longer-term will see USD strength against both the EUR and JPY.

After posting a surprising drop in November to -2.21, or only its first negative print since a freak first half of 2013 aberration, the spin was quick to explain away the drop with the government shutdown, which surprisingly affected precisely nothing else in the economy but just a few diffusion indices (and led to epic surges in various PMI prints). Moments ago, the December Empire Fed PMI print came out, and it was once again a dud, printing at 0.98 on expectations of a rise to 5.00 which also was the fifth consecutive miss to expectations in a row. The decline was driven by ongoing weakness in New Orders, which remained negative at -3.54, while Unfilled Orders tumbled deep into the red, from -17.11 to -24.10, while inventories supposedly cratered from -1.32 to -21.69. We say supposedly because other recent surveys have shown that the surge in inventory accumulation from Q3 into Q4 has continued.

Thinking like the Fed

To know your enemy, you must become your enemy  -Sun Tzu

In war, poker, chess and many other endeavors, wise old hands will advise you to think like your opponent. We’ll try a related idea here by seeing if we can think like the members of the Federal Open Market Committee (FOMC). Specifically, we’ll pretend to write part of the statement for the FOMC’s December 17/18 meeting.

Rebellious Fed head Lacker fired at “implicit guarantees” to bail out bank creditors. Covered liabilities, the size of US GDP.

There are a couple of disturbing points that came out of her take on bubbles and the rationale behind not tapering a mere 10 or 15 Billion dollars given the monthly commitment of 85 Billion in Fed Purchases every month.  

In Feb 2007, Oaktree Capital's Howard Marks wrote 'The Race to the Bottom', providing a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008 as he worried about "carelessness-induced behavior." In the pre-crisis years, as described in his 2007 memo, the race to the bottom manifested itself in a number of ways, and as Marks notes, "now we’re seeing another upswing in risky behavior." Simply put, Marks warns, "when people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed," adding that "the riskiest thing in the investment world is the belief that there’s no risk."

It took Hilsenrath just under a minute to pump out his 1057 (excluding the title) word thesis on the FOMC minutes. As usual, this is indicative of a comfortable embargo cushion which one can be assured was unbreached, as anything else would be very illegal. "Federal Reserve officials had a wide-ranging discussion about the outlook for monetary policy at their Oct. 29-30 policy meeting. The bottom line was that they stuck to the view that they might begin winding down their $85 billion-per-month bond-buying program in the “coming months” but are looking for ways to reinforce their plans to keep short-term interest rates low for a long-time after the program ends.  They struggled to build a consensus on how they would respond to a variety of different scenarios. One example: What to do if the economy didn’t improve as expected and the costs of continuing bond-buying outweighed the benefits? Another example: How to convince the public that even after bond buying ends, short-term interest rates will remain low."

With the schizophrenia that seems to have availed across the FOMC members (hawks are doves, doves are hawks, tapering is not tightening, etc.) it is not surprising that the minutes reflect some confusion:

• *FOMC SAW `SEVERAL SIGNIFICANT RISKS' REMAINING FOR ECONOMY
• *FED TAPER LIKELY IN COMING MONTHS ON BETTER DATA, MINUTES SHOW
• *METLIFE FOUNDATION, SESAME WORKSHOP PARTNER TO PROVIDE FINL
• *FOMC SAW DOWNSIDE RISKS TO ECONOMY, LABOR MARKET `DIMINISHED'
• *FOMC SAW CONSUMER SENTIMENT REMAINING `UNUSUALLY LOW'
• *FOMC SAW RECOVERY IN HOUSING AS HAVING `SLOWED SOMEWHAT'

So summing up - when we get to an unknown point in the future with an unknown state of parameters, we may do an unknown amount of tapering - maybe possibly. Pre-Minutes: SPX 1791, 10Y 2.75, EUR 1.3444, Gold $1262

Somehow, Fed head Bill Dudley has managed to encompass the entire "we must keep the foot to the floor" premise of the Fed in one mind-bending sentence:

• *DUDLEY SEES 'POSSIBILITY OF SOME UNFORESEEN SHOCK'

So - based on an "unforeseen" shock - which he "sees", and while there are "nascent signs the economy may be doing better", the Fed should remain as exceptionally easy just in case... (asteroid? alien invasion? West Coast quake?)

The headline Empire manufacturing data missed expectations by the most since January (the 4th month in a row) and plunged to its lowest since January. Across the board sub-indices collapsed (every one of them) into contraction with shipments down from over 13 to -0.5, and New Orders down from 7.75 to -5.5. "Hope" didn't save it this time either as the outlook droped to 3 month lows. Labor market conditions were subdued. The index for number of employees drifted downward for a third consecutive month, coming in at 0.0 in November in a sign that employment levels were flat (falling at fastest rate in 2013). The average workweek index fell nine points to -5.3, pointing to a decline in hours worked. This can only be great news for the bulls and guarantees that the S&P 500 will hit 1800 today...

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