The Fed–shoot now, ask questions later

The markets had anticipated the Fed would act, but the magnitude of the FOMC’s open-ended commitment to increase its balance sheet was met with a bullish stampede today.

And it wasn’t just stocks. Oil, gold and a host of other commodities gained ground.

The Fed is trying to reflate, and it won’t stop until it sees substantial progress in the labor market. In fact, the Fed’s statement was clear:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

So it's not just looking for improvement. The Fed will continue its bond purchases until it sees "substantial improvement."

At least publicly, it does not believe it will materially add to inflation, but the key question is whether its latest path will aid the economy and move the needle on the unemployment rate.

QE1 and QE2 - or $2.3 trillion in bond buys - have failed to significantly lift the economy. Bernanke even acknowledged in his press conference that "I don't think our tools are that strong."

The Fed chief has said before that monetary policy is not a panacea, but that was an interesting remark as the central bank embarks on a new chapter.

The 3 E’s–Earnings, Economy and Europe

While investors brace for the upcoming earnings season, Europe, and Spain in particular, are still on the radar, while the economy remains front and center.

Sluggish growth has liquidity-addicted traders hoping for a lifeline from the Fed, but the latest minutes the last meeting offered few concrete signs that a new burst of liquidity is on the way.

A few Fed members thought “further policy stimulus likely would be necessary,” but  several others felt new actions “could be warranted if the economic recovery were to lose momentum.”

The Fed will never send a definitive signal of future action, but traders were hoping for something a bit stronger.

With interest rates at a record low, however, many doubt a flood of new cash into the financial system would have much impact on the real economy.

Spain’s bailout–the thrill is gone

A hastily announced bailout of Spanish banks last weekend – to the tune of up to €100 billion ($125 billion) – managed to spark a rally in the Dow that lasted barely an hour on Monday morning.

As we’ve seen in the past, the devil is in the details, and surging Spanish, and to a lesser extent Italian bond yields, are reflecting a market that was not convinced Europe is turning the corner.

Stocks, however, have posted decent gains thanks to growing expectations that the Fed will offer up new measures at its meeting next week.

Further, a report yesterday by Reuters that global central banks may act in a coordinated fashion if credit markets significantly tighten following next Sunday’s election in Greece also supported sentiment.

Attention is now turning to the parliamentary elections in the Hellenic Republic this Sunday. A victory by pro-austerity parties would likely soothe concerns, especially if a coalition can be formed.

However, if the radical left comes out on top, fears of a Greek exit from the 17-nation currency could further jar markets, barring any central bank intervention.

A discouraging nonfarm payrolls report

Nonfarm payrolls rose a disappointing 69k in May, less than half what was expected; June revised downward from 115k to 77k

The unemployment rate rose from 8.1% to 8.2%.

The internals of the nonfarm payrolls number were poor.

I’m hearing some chatter that this is still weather-related payback from a mild winter?  So let’s look at some of the numbers.

· The service sector produced 218k in Feb, including 89k in professional and business services in Feb.

But in May those categories fell to 97k and -1k, respectively.

It’s hard to argue that a hiring manager in a high-rise looks out the window and checks the Weather Channel before making his/her hiring decision.

If there is a silver lining, the household survey that measures the unemployment rate showed a 422k rise in employment, but a 642k increase in the labor force produced the 0.1% increase in the unemployment rate. Pick up in June activity?

This is a volatile measure of employment and markets ignored it. DJIA futures went from -100 to -200 in the blink of an eye, and the 10-year Treasury fell from 1.53 to 1.48%.

The Fed –

This raises chatter of QE3, but the 10-yr is already near 1.5%!

If the Fed wants to get rates down, Europe and economic worries are accomplishing this. However, the action in the bond market, coupled with weakness in employment and commodities is troubling. And low rates just aren’t jump-starting growth.

That a monetary policy that focuses on asset appreciation. Still, there’s only a tenuous link between higher stock prices and consumer action. And the blunt action of Fed bond buys could reignite commodity inflation.

But if the Fed moves ahead, purchases of mortgage-backed securities may be considered, as the 30-year fixed mortgage has badly lagged the drop in the 10-year Treasury.

One last point, action in commodities and the recent “collapse” in 10-year yields is worrisome. The bond market, which does a better job than the stock market in terms of future activity, is screaming the “R” word.

Bernanke’s testimony next Thursday now becomes an even bigger market event.

Bernanke talks unemployment

Ben Bernanke's primary focus in today's speech - the unemployment rate.

While some in the press attribute today's advance in equities to Bernanke's positive spin on the recent decline in the unemployment rate, I tend to believe that his caveats temper his optimism.

Bernanke called the "notable decline in the unemployment rate" to be "good news," but immediately added, "some key questions are unresolved." And he's not optimistic that the recent rate of decline will continue unless we see a pick-up in growth.

What may be driving equities today (Treasury yields are higher), his remark that the "Federal Reserve's accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well” may be the primary driver.

And he reiterated at the end of his speech that "accommodative policies to support the recovery will help address this problem (cyclical unemployment) as well."  He clearly didn't back away from some new form of QE3, but it's a tougher calls as to whether he inched back toward it (gold is up). Goldman Sachs, for examples, expects QE3 sometime in Q2.

Finally he cited three possible explanations for the recent dip in unemployment.

• The first two, he mostly dismissed: GDP data will be revised upward and discouraged workers have left the labor force. He did not, however, provide much explanation on the substantial decline in the labor force participation rate.

• The third explanation - firms fired too quickly in 2009 and are now playing catch-up - was his most likely reason for the recent dip in the employment rate (see chart below from Bernanke's speech)

While Bernanke believes much of the still-high rate of unemployment is cyclical and not structural - and I agree - I tend to disagree with his assessment that firms laid off too quickly in 2009  - see chart below:



The drop in GDP matched the drop in nonfarm payrolls.

Since Bernanke believes the high rate of unemployment is being caused primarily by a lack of economic growth, QE3 remains an option. And this has implications for bond yields, money markets, CDs etc.

Of course, it also has implications for stocks and potentially commodities.

Fed statement–little change

A very quick and cursory look at the just-released Fed statement - 2:15 pm ET - revealed mostly a carbon copy of January's statement. And maybe just a slight upgrade in the outlook.

The Fed said:

• the economy is expanding moderately and it expects moderate economic growth over the coming quarters.
• the unemployment rate has declined notably but going forward, it anticipates just a gradual drop
• higher oil and gasoline will have just a temporary impact on inflation before it eventually slows (added)
  • With the economy still on an uneven footing, would the majority on the Fed really acknowledge a concern about inflation? Seems unlikely as that would force their hand and it would send LT rates soaring.
• no changes in any language regarding a third round of QE

None of this is really any surprise.

The Fed may just be setting the stage for something more significant at its two-day meeting in April (March's was just a day).

Final demand, which has befuddled policymakers given the relatively upbeat nonfarm payroll numbers, may hold the key for any new round of easing.

Sterilized bond buys appears to be the most likely part if we have a new move.

Retail sales
Good news on the retail front this a.m., and the upward revisions to January were welcome. But taken together with the weakness in Nov and Dec, it's steady as she goes. Still, I'll take upbeat numbers at the margin any day.

All this suggests the consumer is feeling better moving into the new year, as higher consumer confidence translates into more spending, despite the surge in gasoline prices.

Fed opens door wider to QE3

We're not there yet but comments coming out of yesterday's Fed meeting strongly suggested that the Fed will eventually implement a new round of QE3.

None of this should come as a surprise since a majority of Fed voting members have been bemoaning the high rate of unemployment for a while.

Sure we've seen a modest pick up in growth since the summer, but progress on unemployment has been slow, and publicly, that is the Fed's reason for its focus on QE3.

Economic projections are far from rosy

1. Sluggish GDP growth. In fact, a slight dip in the GDP forecast from Nov.
2. Slow progress on unemployment.
3. Subdued inflation within the Fed’s target.

In Bernanke's opening statement of his press conference, he said the Fed is "prepared to provide further monetary accommodation if employment is not making sufficient progress towards our assessment of its maximum level, or if inflation shows signs of moving further below its mandate-consistent rate.”

So if inflation slips some, the Fed has the extra wiggle room to buy bonds. Helicopter Ben couldn't pass up that opportunity!

And he added in a follow up to a question that QE3 is an “an option that’s certainly on the table.”