Monday, January 11, 2010

All eyes on the Fed in 2010

If there is a common thread through the numerous outlooks I have read, it is that there is widespread optimism for investor's in 2010. It is cautious optimism, without doubt. Many experts are, in one way or another, agreeing that the stock, commodity and bond markets are not functioning as they are designed to, but they are functioning, and they are rewarding risk taking. What that might mean is that the functioning of the markets is being administered to a desired outcome, despite the will of free market forces. That is what it means to me.
Who might be the administrator of the markets and what is the desired outcome? Let me see if I can find an answer, using his own words.

Chairman Bernanke gave his speech at the Economic Club of New York on November 16, 2009. The speech is titled On the Outlook for the Economy and Policy. I think there is little room for arguing on the points he makes, unless you just completely disagree with everything he says, like say Michael Shedlock. The Bernanke speech made these observations about 2010... I return now to the outlook for the economy and policy. As I noted, I expect moderate economic growth to continue next year. Final demand shows signs of strengthening, supported by the broad improvement in financial conditions. Additionally, the beneficial influence of the inventory cycle on production should continue for somewhat longer. Housing faces important problems, including continuing high foreclosure rates, but residential investment should become a small positive for growth next year rather than a significant drag, as has been the case for the past several years. Prospects for nonresidential construction are poor, however, given weak fundamentals and tight financing conditions.

In the business sector, manufacturing activity has been expanding and should be helped by the continuing strength of the recovery in the emerging market economies, especially in Asia. As the recovery takes hold, enhanced business confidence, together with the low cost of capital for firms with access to public capital markets, should lead to a pickup in business spending on equipment and software, which has already shown signs of stabilizing.

It seems to me, that expecting anything more than what Bernanke has described here takes a lot of courage. Put yourself in his shoes. (LOL) You are perhaps the most powerful person in the world, at least as powerful as your closest power person competitor. You have all of your closest friends and political supporters (Treasury, Congress, Council of Economic Advisors, Goldman, Morgan, Wells, BofA, Citi, and AIG, etc. ...) around you, giving you all they can, both publicly and discreetly, and you have to do your job of influencing how the economy functions with the tools available to you, or, that you can create on short notice. The only problems that can mess this up are those that are out of your control, such as a foreign crisis of significance. Dubai World's $59 billion default was too small. Maybe a failure within the domestic credit system that ignites a populist fire and that forces you to declare this is outside of your political scope.

Meantime, Doug Noland, a well known and regarded bear, has these assumptions at work in his outlook for 2010:
The Fed’s overriding focus is stimulating sustainable recovery. They will err on the side of caution when it comes to removing crisis-period liquidity measures. I will assume that they will not be raising rates meaningfully until they are confident that the markets and economy have first adjusted well to ending quantitative easing operations. Meaningful financial tightening is nowhere in sight. The Bernanke Fed still believes that monetary policy is a “blunt tool” and, as such, is inappropriate for dealing with Bubbles. They prefer stronger “regulation.” So, who is responsible for regulating Washington Credit excesses?

Today, the markets are infatuated with risk assets. From the perspective of Bubble analysis, this is not all too difficult to explain. The first week of the year saw about $45 billion of corporate debt issues. Despite enormous new supply, investment grade debt spreads are at pre-Lehman crisis levels. The same can be said for junk bond and emerging debt spreads. Credit conditions are loose for most creditworthy borrowers, which feeds market demand for these debt instruments - which translates into even greater Credit Availability. In such an environment, even commercial real estate doesn’t look so bad. But is such an accommodating financial landscape sustainable?

It is always impossible to know what developments will surface to upset the applecart: there are any number of festering financial, economic, political, and geopolitical issues that might impede the unfolding Bubble. At the same time, it is not unreasonable to suspect that policymakers might tend to delay dealing with tough issues. The federal deficit is out of control, and monetary policy is outrageously loose. There is an “exit strategy” with assorted doors. There is the looming issue of Fannie and Freddie. The FHA and Ginnie need to be reigned in.

Looking back, policymakers of all stripes missed their opportunities to make tough but necessary decisions in 2009. And now 2010 just doesn’t have the feel of a year that will witness a lot of decisive policymaking. In Washington, the focus will turn to the 2010 elections. The Fed will worry about its reputation and independence. Fearing for their jobs and fearful of mistakes, timid will win over bold.

This will be a good year to anticipate Fed policy moves, by closely monitoring all information available to us. It does not take an economic guru to tell us that when markets believe trends will change, it is reasonable to expect an outgoing tsunami wave of asset value's, again. There is no harm to being early. Compare that to being late. Scanner