There Is A Considerable Gap Between What The Fed’s Saying And What It’s Thinking

The Federal Reserve is clearly committed to promoting growth at the risk of inflation. However, as regular readers of this column will be aware there is a significant difference between asset price inflation, the perception of growth and real economic growth. By real economic growth I refer to the type of economic activity that through investment and innovation creates new businesses, new jobs and thereby new streams of economic wealth.

Eight months of strongly rising stock and commodity prices should be the reassuring confirmation that investors, consumers and businesses are enjoying stronger economic activity. However, the asset price inflation of risky assets does not by itself prove stronger economic fundamentals are in place. Asset price inflation only proves demand in excess of supply, more buyers than sellers of risky assets.

So whilst the US economy has nominally exited recession economists are entitled to discuss whether the recovery has been manufactured by the Fed’s ultra-loose monetary policy and the US government’s stimulus efforts - both of which must and will be retracted in 2010, or if the recovery was prompted by sustainable and real economic activity.

The Fed understands this issue and therefore has a balancing act to execute. It needs to talk “recovery” and cite improving fundamentals as such statements support business and investor confidence. But it is also needs to keep the stimulus in place in the hope that its successful asset price inflation exercise translates into investment in new projects (venture capital and jobs) rather than just more speculation in existing assets (stock and commodity trading).

This Fed waiting game can only go on for so long. Eventually the hundreds-of-billions-of-dollars of stimulus and low interest rates will create a new asset price bubble as prices stretch beyond fundamentals. After all it was the loose monetary policy seen earlier this decade combined with poor financial risk controls that primarily caused the 08/09 recession.

So this week’s statement from Fed officials that a weak economic outlook is subduing inflationary pressures in the real economy is both grim but predictable. Grim, because it means there is no sustainable economic recovery yet in motion. Predictable, as the vast majority of recent stimulus has been spent saving flawed businesses like GM or shoring up the balance sheets of ethically and intellectually challenged banks allowing them to re-enter markets and speculate like the good old days.

It’s not all bad news though. US consumers have started to rebuild their personal balance sheets - saving a larger proportion of their income. But this process could continue for a decade and a ratio of higher saving relative to spending will hold back the recovery further.

It may already be too late to stop the US economy from fading back into another recession within 2-3 years and the next contraction will see a higher peak in unemployment than in this recession whilst the government and Fed will be less capable of providing effective stimulus as the country will be more indebted going into the next recession than it was entering this one.

As for the dollar, the Fed talks of its desire for a strong currency, but in reality it desperately needs a depreciating, though not collapsing, dollar to boost the demand for US made goods.

I would suggest there is a considerable gap between what the Fed is saying:

1. Investor confidence improving.
2. Low rates can stay as inflation pressures remain subdued.
3. Strong dollar good.

And what is it thinking:

1. Risks of another asset price bubble are increasing fast.
2. Low rates have to stay in place as neither businesses nor consumers are ready to maintain the recovery.
3. Weak dollar good.

Chart: USD Index Weekly to 20th November. Source: StockCharts

Gold, Short-term Vulnerable, Long-term Strong

Gold entered volatile territory towards the end of the week as traders were torn between the short-term overbought scenario and strong longer-term fundamentals.

A significant proportion of gold traders are articulating the view that any short-term retreat on profit-taking is likely to be short-lived as buyers would use the opportunity to increase exposure to the precious metal confident the longer-term upward trend is intact.

Chart: Gold Weekly to 20th November. Source: StockCharts

However, in the next few sessions the rally does look vulnerable with gold’s Relative Strength Index, a useful guide to the sustainability of recent price momentum, indicating the prices are extremely overbought in the short term.

Investors less familiar with gold trading should also monitor the US dollar closely due to its inverse relationship with gold. If the dollar reverses its recent weak trend and rallies, the probability of a retreat in the price of gold increases strongly.

If a burst of profit taking does take hold, two of gold’s key support levels will be $1,100 and $1,050. $1,000 represents a major psychological support level and is not expected to be breached on even aggressive profit-taking. Looking forward, when the bullish trend reasserts itself $1,250 represents a very strong resistance level and markets will probably need at least three attempts on the price before further upward progress can be made.

Goldman Sachs (NYSE:GS) Bonuses under Focus

Some of GS shareholders are pressing the investment bank to review the level of bonus payouts to staff. The shareholder request follows wider public discontent at the degree of profits made by the bank and its pay plans following its announcement is has set aside $17bn for bonuses. Although GS has repaid a $10bn government bail-out many commentators feel such gross remuneration is at best inappropriate with the wider economy still struggling. The Wall St Journal has reported the average bonus per staff member is to be in excess of $700,000.

Chart: GS Weekly to 20th November. Source: StockCharts

Philip Morris (NYSE:PM) suffers Ex-smoker’s Litigation

Goldman’s brand problems pale into relative insignificance compared to the tobacco firm Philip Morris. A Florida court has order Philip Morris to pay $300m in damages to an ex-smoker suffering from emphysema. The latest ruling is one of 8,000 potential claims which formed part of a 2006 class action against the cigarette producer. A small percentage of claimants within the class ruling have been given the authority to pursue individual litigation. Philip Morris responded describing the $300m award as “grossly excessive”.

Chart: PM Weekly to 20th November. Source: StockCharts

OECD Remains Unimpressed At UK Efforts to Fix Deficit, Restore Growth

The Organisation for Economic Co-operation and Development has downgraded its prediction for UK economic growth. The respected think-tank now suggests the British economy will contract by 4.7% in the current year, down from its earlier forecast of a 4.3% contraction. The OECD also predicts a weak recovery in 2010 with1.2% growth and observed the UK government had already run out of stimulus ammunition.

In a generally critical report the OECD also remarked the UK government had failed to provide clarity regarding its strategy for tackling the budget deficit observing the deterioration in the UK’s finances was damaging its credibility in international financial markets.

The OECD report coincided with official government figures relating to its total public sector debt for the end of October which grew to £829.7bn, 59.2% of GDP. The fiscal year-to-date figure stands at £86.9bn. October’s single month borrowing figure was also poorer than expected at £11.4bn, representing the worst October data on record but better than the prior two months borrowing of £14.1bn and £14.9bn respectively (August and September).

UK government bond prices fell on the news as investors speculated weaker demand for UK Gilts going forward at current yield levels.

The UK government had forecasted a borrowing requirement of £175bn for the 09/10 tax year though a figure of closer to £200bn looks increasingly likely.

Closing its economic analysis the OECD kicked sand in the face of British economic leaders one more time and noted most of the momentum behind the global economic recovery could be credited to Asia and China whilst suggesting the Bank of England’s quantitative easing program was to-date “ineffective”.

UK Inflation Rises as Energy & Transport Costs Mount

Prices rose in October with inflation rising to 1.5% year-on-year in October compared to 1.1% annualised a month earlier. The data was in line with forecasts. Whilst current inflation levels remain modest many economists predict the rate of inflation will continue to accelerate, and become more volatile as the government reverses recent VAT cuts and consumer prices bounce back from the last year’s recessionary trough.

Inflation will surpass the Bank of England’s nominal 2.0% target early in 2010.

UK Housing Market Recovery Stalls Pre Christmas

After a strong six months UK house prices stalled October into November as sellers pressed to close transactions pre-Christmas and buyers refrained from entering negotiations planning to revisit the property market again in the New Year. Rightmove, the online property specialist, reported asking prices have fallen by an average of 1.6%. Rightmove also commented the government’s extension of the stamp duty holiday for properties under £175,000 had proved “irrelevant”. The tax-free extension now expires in December.

The property marketing firm suggested new home listings were 30% lower than the same month 2 years ago, close to the peak of the property bubble, and that further house price falls were likely until February when the market traditionally sparks into life again.

Nationwide Building Society re-affirmed the cautious view and reported a 64% slump in first half profits. Nationwide attributed the sharp reduction in profitability to asset price write-downs against its commercial property portfolio and margin pressures due to low interest rates. Nationwide also cited growing unemployment as likely to hold back house prices into 2010 and predicts higher levels of residential mortgage arrears going forward.

Nationwide’s claim that margins are under pressure, in part, due to low interest rates are harder to justify under close examination. The base rate is 0.50%. Nationwide allows existing ‘low deposit’ customers to take out a home loan with a loan-to-value ratio of up to 95% on a three-year fixed rate of 6.73% or a five-year fix at 7.48%. It then allows, subject to further income and credit checks, customers to borrow an additional 30% of their home value at rates of 7.23% and 7.98% respectively. Eagle eyed mathematicians will quickly note borrowers can again borrow up to 125% of their property equity.

Commission driven mortage brokers welcomed the negative equity ‘deal’ and a similar one offered by the Coventry Building Society with one broker commenting the 125% mortgage deals were a “no brainer”. My thoughts exactly.

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