Submitted by Lance Roberts of STA Wealth Management,
As the S&P 500 continues to push to one new high after the next, the bullish arguments of valuation have quietly given way to "it's all about the Fed." The biggest angst that weighs on professional, and retail investors alike, are not deteriorating economic strength, weak revenue growth or concerns over the next political drama - but rather when will the Fed pull its support from the financial markets.
Deutsche Bank's Peter Hooper, states that he isn't sure when the Federal Reserve will begin to taper its stimulative, $85 billion monthly purchases of Treasury and mortgage securities. He assigns equal odds for each month.
However, while Peter's arguments are just as good as any, I have a slightly different view.
First of all, I find it highly unlikely that the Fed will taper its purchases in December as the government once again begins to debate over raising the debt ceiling. As I stated in "The Real Reason For No Taper," following the surprise decision this past September:
"The problem the Federal Reserve currently faces is that they are once again facing an issue that nearly cratered the markets, and the economy, back in 2011. As we quickly approach the limit of the government's borrowing capability, the threat of a government shutdown and 'debt ceiling' debate once again looms. Bernanke is currently fearful of such a repeat event given an already weak economy coupled with rising interest rates. Any shutdown of the government, fear of "default" or restrictive fiscal policies could collapse what incremental recovery there has been to date.
Therefore, at least for now, the clearest path for the Federal Reserve was to risk the building of an asset bubble, which they feel that they can control the deflation of, versus an economic drag that pulls the economy back into a recession. Unfortunately, there is absolutely no historical evidence that the Fed can control the deflation of an asset bubble"
The bill that was signed this past October to end the government shutdown effectively gave control of the "debt ceiling" to the President. Therefore, it is unlikely that the upcoming debate in January will be nearly as exciting as the last. However, there is likely to be a fight over fiscal policy changes which could rattle the markets nonetheless. Therefore, the Federal Reserve is unlikely to reduce its accommodative monetary policies, with an already weak economic environment, ahead of an upcoming battle in Washington that could lead to potentially restrictive fiscal policy outcome.
Furthermore, it is very interesting to note that a wide variety of analysts and economists sincerely believe for a third year running, that economic growth will accelerate in coming months. However, there is no evidence of such an acceleration currently in the economic data. In fact, much of the economic data points to an economic environment that is actually decelerating. The ongoing effects of higher payroll taxes, and most importantly higher healthcare costs due to the onset of the Affordable Care Act, will continue to reduce the net disposable income of consumers which make up 2/3rds of economic growth. I discussed this recently in regards to retail sales stating:
"However, there is one dynamic that has yet to fall into most analysts radars - the impact of the Affordable Care Act. With the new revelation that as many as 14 million healthcare plans will be cancelled; the number of individuals having to pay more for healthcare is increasing.
What does this have to do with retail sales? Just about everything. The chart below compares the level of retail sales to personal incomes. See the correlation?
Those incomes are not rising. If we substract an additional $200-300 per month for the additional cost of governmental healthcare - where does the money come from?
The problem for the average American is that their income is very finite. According to a recent CNN Money survey roughly three-fourths of all American's are already living paycheck to paycheck. Of course, this should not be surprising with roughly 90% of the population earning less than $50,000 on average.
That increase in the cost of healthcare, combined with the increased taxes from the ACA itself, will have a negative impact on both retail sales and the more comprehensive personal consumption expenditures report which feeds directly into the GDP calculation."
So, why not March?
A March taper is also unlikely as the Federal Reserve will be dealing with two primary issues at that point. The first will be evaluating the impact of whatever deal was struck in Washington during the January/February debt ceiling-budget debate. Secondly, will be the upcoming transition of control at the Federal Reserve from Ben Bernanke to Janet Yellen. Considering that Yellen is potentially even more dovish that Bernanke in terms of monetary policy it is highly likely that the Fed will opt to leave current policy in place during the transition process.
On the economic front, it is unlikely that the labor market will have improved enough by March, or potentially worsened, to warrant reducing the current program. It is not lost on the Fed that the majority of the decline in the unemployment rate has been driven by declines in the "labor force" participation rate. Achieving a target of 6.5% unemployment would be a hollow victory, economically speaking, when a large percentage of the working age population is effectively not counted and living on welfare. (Currently 49.2% of all working age Americans are currently participating in some form of government assistance.)
Importantly, William Wascher and David Wilcox just recently released a new paper discussing evidence of the significant deterioration of the supply-side economic performance in the U.S. The implications are important as it points to continued "very slow" potential GDP growth and an increase in structural unemployment.
(Via ZeroHedge) "They estimate that real potential GDP growth has only averaged 1.3% since 2007, the output gap is currently about 3% of GDP, and the structural unemployment rate had risen to 5.75% by 2012 (although it is now again on a slight downward trend). They then use a modified version of FRB/US with an added role for "hysteresis" in labor markets--that is, a gradual transformation of cyclical unemployment into structural unemployment and/or labor force withdrawal --to analyze the sources of this deterioration, using a simulation in which the model economy is hit by a major financial crisis that is calibrated to match the size of the 2007-2009 episode. In a nutshell, they find that the post-crisis period 'features a noticeable deterioration in the economy's productive capacity' and that about 80% of the deterioration '…represents an endogenous response to the persistently weak state of aggregate demand.'"
Furthermore, falling levels of already low inflation rates suggest that the economy is slowing rather than expanding, housing is slowing as the run of speculation is ending with higher interest rates, and the markets have already shown a nasty response to "taper talk" previously.
Not Until The End Of 2014 - If Ever
As I discussed recently in "What Is A Liquidity Trap And Why Is Bernanke Caught In It?" the problem for the Federal Reserve is that when they attempt to reduce liquidity support from the markets, as they did in 2010 and 2011, it immediately results in a selloff in financial markets, a loss of consumer confidence and a downturn in economic growth. Even talk of "tapering" earlier this year had similar consequences.
Goldman Sachs had three very important takeaways:
"First, the studies suggest that some of the most senior Fed staffers see strong arguments for a significantly greater amount of monetary stimulus than implied by either a Taylor rule or the current 6.5%/2.5% threshold guidance.
Second, the studies provide two complementary reasons for why additional easing is warranted, and;
Third, the studies suggest that the most likely form of this additional easing would be a reduction in the 6.5% unemployment threshold."
While Goldman thinks that such an analysis implies a "taper" in March, alongside a reduction in the Fed's unemployment target to 6.0%, the reality is that it more likely infers that there will be the talk of more, rather than less, accommodative monetary policy particularly as Yellen takes control. This will particularly be the case if I am correct about the impact of the Affordable Care Act on the economy in the months ahead. (The full impact of ACA will not be felt until 2015 when the corporate mandate engages. This will cause a significant transference of costs to the individual without an offsetting increase in wages.)
"The lack of transmission of the current monetary interventions into the real economy has remained a conundrum for the Federal Reserve as the gap between improving economic statistics and the real underlying economic fabric continues to widen. As Larry states, we are indeed in uncharted territory. With the direct manipulation of interest rates near impossible, it leaves only verbal (forward guidance) and liquidity (increases of excess reserves) policy tools available. The problem is that these tools have never been used to such a massive extent before in history. While analysts and economist continue to suggest, with each passing year, that stronger economic growth is coming; it has yet to be the case. As discussed previously, this is a tell-tale sign of a liquidity trap.
My belief all along has been and remains that a well thought out combination of both fiscal and monetary policy is the correct remedy for what ails the U.S. economy currently. However, up to this point, the Fed has been the 'only game in town' to quote the famous words of Senator Chuck Schumer. I have to admit that I was pleasantly surprised by Larry Summers view point as I believe that it is the correct one at this late stage of the current economic recovery cycle."
For the Federal Reserve, they are now caught in the same "liquidity trap" that has been the history of Japan for the last three decades. With an aging demographic, which will continue to strain the financial system, increasing levels of indebtedness, and poor fiscal policy to combat the issues restraining economic growth, it is unlikely that continued monetary interventions will do anything other than simply foster the next boom/bust cycle in financial assets.
Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S? More importantly, this is no longer a domestic question - but rather a global one since every major central bank is now engaged in a coordinated infusion of liquidity. The problem is that despite the inflation of asset prices, and suppression of interest rates, on a global scale there is scant evidence that the massive infusions are doing anything other that fueling the next asset bubbles in real estate and financial markets. The Federal Reserve is currently betting on a "one trick pony" that by increasing the "wealth effect" it will ultimately lead to a return of consumer confidence and a fostering of economic growth? Currently, there is little real evidence of success.
Will the Federal Reserve "taper" in December or March - it's possible. However, the revulsion by the markets, combined with the deterioration of economic growth, will likely lead to a quick reversal of any such a decision.