QE vigilantes 1, The Fed 0

Surprise! Most, including myself, had expected the Fed to announce a tapering at today's meeting. My view - likely in the $10 billion range.

Instead, there was no change in policy.

My thoughts:

1. The Fed doesn't have much confidence in its economic outlook

2. The Fed is concerned about the back-up in interest rates and the possible effect on housing

3. There is some concern about fiscal restraint and the budget battles that loom.

Much of this comes directly from the Fed's statement.

Just to illustrate: 

“The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market (italics,underlined my emphasis and a new addition to the September statement vs the July statement).

"...but mortgage rates have risen further and fiscal policy is restraining economic growth."

Stocks surged, with the Dow and the S&P hitting a new record, but the focus will shift to the upcoming budget battles. Plus, will investors get that uneasy feeling since the Fed isn't seeing the kind of economic activity they had envisioned?

For now, the QE vigilantes that drove rates skyward seem to have forced the Fed to blink, and Bernanke is no longer so focused on a jobless rate that had given him the green light to taper.

Damage control, feral hogs, and the QE vigilantes

It's just been a few days since Bernanke told us that QE is on the chopping block if the economic data play out like the Fed expects. Market reaction, however, has been less than kind.

So we're seeing some damage control today by a couple of more hawkish Fed members - non-voting FOMC members but nonetheless influential Fed members.

First, Minneapolis Fed head Kocherlakota felt compelled to issued a statement saying it may be appropriate to keep the fed funds rate at an extraordinarily low level at least until the unemployment rate falls below 5.5%. Recall that Bernanke's threshold is 6.5%.

Then we have the always colorful Dallas Fed President Richard Fisher who told the Financial Times, "...big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”

Though he has never been a fan of QE, he repeated he doesn't want to go from" wild turkey to cold turkey overnight."

This brings us to a new group of bond traders on the Street - the QE vigilantes.

Most of have heard of the bond vigilantes.Wikipedia offers a good definition - When investors perceive that inflation risk or credit risk is rising they demand higher yields to compensate for the added risk. That in turn helps keep inflation and government spending in check.

In recent years, the vigilantes have been dormant against the backdrop of trillion dollar deficits. A lack of near-term inflation anxieties are playing a role.

Those inflation bond vigilantes may now be morphing into the "QE vigilantes," as they launch waves of bear raids on the market, hoping to slow growth and force the Fed to keep the liquidity hose aimed at the bond market.

Fisher is standing in the gap.

The Fed's 360 degree door

Today's testimony by Fed Chief Ben Bernanke, as well as the minutes from the latest Fed meeting released later in the day, gave central bankers a door to pursue any number of policy options.

Let me explain. Early today, Bernanke testified before a Congressional committee that a premature tightening of monetary policy would carry substantial risks.

Got it. The Fed won't be paring back on bond purchases anytime soon.

Then, during the Q&A session, Bernanke said the Fed could reduce QE in the next few meetings, but added that it all depends on the data. Hmmm.

Muddy minutes
To make matters even more interesting, the Fed's minutes included this statement.

"A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome."

But the minutes also referred in a number of instances to "downside risks."

So Bernanke is warning against a premature tightening, but a number of participants are expressing a willingness to cut back on bond buys, possibly by June.

Confused? The Fed sure seems divided. Or maybe it just doesn't want to clearly communicate when it might be start to taper off as it is worried the Street would quickly price in any exit.

Bottom line - the Fed has shifted the gravity of its position towards tapering off, but it has kept the door open to any number of policy responses if conditions warrant. It's a policy for all seasons.

Federal deficit? What deficit

OK. So a CBO estimate of a FY2013 federal deficit of $642 billion is still $642 billion. But its $200 billion less than the CBO estimated just three months ago. And it's well below the $1.1 trillion 2012 federal deficit.

So what gives? Simple. Revenues are coming in faster than expected thanks to a "modest-at-best" economic recovery that is putting folks back to work and creating taxpayers. Moreover, repayments by Fannie and Freddie are also helping.

And let's not forget that spending restraint - federal spending will fall for the second year in a row - is also helping to sop up the red ink quicker than anyone thought possible.

At 4% of GDP and falling, the deficit is finally becoming manageable.

The next question - is the CBO estimate still too conservative?

The CBO said last August that the deficit would fall to $641 billion if the country went over the fiscal cliff. Wow! That's one helluva of a miss. But it also highlights the difficulty in forecasting revenues and spending.

At least for 2013, the country was able to extend the Bush tax cuts to 99% of the population and come within $1 billion of hitting the CBO's target.  Let me repeat - all without a cliff-induced recession!

Is the deficit falling too quickly? 
Sounds like an odd question to ask, but pulling cash too quickly out of the economy could slow growth.

So those who favor a more activist government would argue that additional government spending would slow any fiscal drag and create more jobs.

Those who want to see the government get out of the way would argue there is room for more tax cuts, which would unleash additional business and consumer spending.

You make the call.

Stocks - like watching the grass grow

Seemingly inspired by last week’s ‘sigh of relief’ employment report, the major stock market indices topped new milestones in what can only be described as a ‘watching the grass grow’ rally.

Sure, it’s been dull, but who says rising portfolio values have to be accompanied by heightened exuberance. 

Same 'ole, same 'ole 
Earnings season is winding down, and you know it's a slow week when the most important economic report is weekly jobless claims.

But the general themes that have been in place since the beginning of the year - stronger corporate profits, accommodative global central banks, an expanding economy, and very quiet credit markets - were all a part of the equation.

Oh. In case you were wondering, jobless claims hit a fresh 5-year low.

The European Central Bank finally delivers on a rate cut

The euro-zone remains bogged down in a recession, and after a new record for unemployment - 12.1% - and a drop in it's CPI  to a rate of 1.2%, the European Central Bank finally threw in the towel and offered up what I would call a symbolic rate cut of 25 bp to 0.50%.

Whoopee! Sadly, Europe's in a world of hurt, and a 0.25% reduction in its key rate won't solve what ails its economy.

One reason in particular came to light in the ECB's press conference, which traditionally follows its monthly meeting.

ECB President Mario Draghi remarked, and I'll relay his complete statement before commenting, "In the U.S., 80 percent of credit intermediation goes via the capital market. Capital markets rate and price assets in a right or wrong way, but it’s fairly transparent.In the European situation, it's the other way around; 80% of financial intermediation goes through the banking system."

That's a huge problem for Europe, but it highlights one reason the U.S. economy has managed to plow ahead, even if it's at a sub-par pace.

You see, U.S. banks weren't lending during the recession and in the initial stages of it's recovery. In fact, standards are still on the tight side. But access to capital via capital markets provided some lift.

European businesses depend on banks for support, and their banks are under-capitalized and aren't lending. In fact, they'll need to raise hundreds of billions of euros in capital or shed trillions in assets to get capital ratios where they need to be.

That means Europeans will have to navigate a very rocky road in the coming months and years..

Euro-zone problems continue

Earlier in the week, we found out that the euro-zone unemployment rate held at a record 12.0% in February, highlighting the difficult problems being faced by policy makers on the other side of the Atlantic.



Today, the European Central Bank offered little comfort with the exception of touting its past achievements that have kept the woefully under-capitalized banking system from blowing apart at the seems.

I guess we really should be thankful for small favors.

ECB President Mario Draghi still believes the euro-zone will experience  a gradual recovery in the second half of the year, but he added a caveat - that any recovery is “subject to downside risks.”

It sounds as if he may be losing a little faith in his own forecast. At 75 bp, monetary policy is accommodative, but he’s not offering much more stimulus.

A rate cut was discussed “extensively,'” but a 25 bp or even a 50 bp rate reduction would be mostly symbolic. And don’t expect much in the way of fiscal stimulus.

Europe’s in a mess, and its weak banking system isn’t in a position to supply needed credit.

All this shouldn’t be lost in the U.S. investor. Sure, the market has pierced all-time highs, but weak sales in Europe seem likely to hinder profits at home.

Keep an eye on comments from the multinationals, as they report profits.

Cyprus keeps it interesting

We watch Europe quiet down, at least for a while, and then problems resurface. This time it's Cyprus.

The European Central Bank has done a remarkable job of holding the financial system in Europe together, but what is truly needed is economic growth. Until the recession in Europe ends, its under-capitalized banking system will remain under considerable stress.

Still, muted market reaction in the U.S and in Europe - a lack of reaction in Spanish and Italian debt yields - is signaling a lack of anxiety over contagion.

Monday is the deadline for Cyprus to accept German/IMF terms. If Cyprus rejects, its banking system will collapse, and we will likely see some renewed volatility, as the market tests ECB President Draghi's pledge to do whatever it takes to preserve the euro.

If Cyprus cries "uncle" (it really doesn't have much choice and that is what markets are pricing in), we limp through the latest euro-zone debt crisis.

Cyprus hopes to trip up the bulls

Over the weekend, news broke that Cyprus will levy a tax on its depositors to help with a bailout of its faltering banking system.

Not surprisingly, we saw a run on ATM machines in the country, but no bank lines as the financial institutions were closed today and are expected to be closed until Thursday.

The uncertainty created by the situation on the tiny island in the eastern Mediterranean shook global markets amid concerns that we might evenutally see a repeat in larger countries like Spain or Italy. The last thing we want to see is Italian depositors lining up around the block, demanding their life savings.

Stocks in the U.S. opened lower but pared losses by the close. In a flight to safety, Treasuries jumped as trading began but came off highs as cooler heads prevailed. Even better, junk bond fund fully recovered from early losses. Want a canary in the cold mine? High-yield funds are the closest you'll get.

What we saw today was an attempt by U.S. markets to sort through the noise.

But let's take a step back. Cyprus is barely 0.25% of euro-zone GDP, and countries such as Greece, Italy, Spain, Portugal, and Ireland have failed to sink the euro.

I don't have a crystal ball, but it seems unlikely that a cataclysmic euro-zone event might originate with Cyprus. Volatility? Probably. Stocks never move in a straight line.

Bottom line - Europe's problems have subsided and the relative calm in the credit markets has been a boon to U.S. stocks - think the removal of a roadblock. As we saw today, euro-zone woes haven't been put to rest.

The Dow tops a psychological milestone

The bulls have been gunning for the Dow’s all-time high for several weeks, and on Tuesday, positive sentiment finally helped the oldest and best known of the major market averages close above a threshold that hadn’t been seen since Oct 2007.

Yes, it may be just a psychological barrier, but it’s one that gets plenty of attention. And today, in a rocky session, the Dow added another 42 points.

General themes that have been driving equities higher include:

· Slow but steady economic growth

· Profits are topping a low hurdle

· Quieter credit markets in Europe (more of a removal a roadblock)

· The search for yield

· A very accommodative Fed policy

· The renewed interest in LBOs and mergers

· A sense that China’s economy won’t stall

· Europe is expected to exit its recession later in the year

· The fiscal cliff was avoided at the beginning of the year.

Are there risks? You bet. Some include the possibility that European credit markets could flare-up again, China could experience a hard landing, or the U.S. recovery could stall.