Economic Condition Review: June 2011

The last economic review I did for the blog was in January 2011. At that time conditions for the US economy felt hopeful with corporations getting ready to announce good to great business results and guardedly optimistic business outlook messages. Food and energy inflation were an established factor in the US and the rest of the world. QE2 was adding fuel to inflation and to the prices for most commodities, especially the money hedges, gold and silver. The US$ was weakening, reaching a recent low near 73 (see graph below). A review of the weekly market data for January 14 is linked here. Company share prices elevated for much of the early part of earnings season before hitting a ceiling in mid February and suffering a March pullback in sympathy with Japan's enormous tragedy trio, earthquake, tsunami and nuclear power plant catastrophe's. The US markets recovered to the year-to-date high at the end of May.

Now in June, the world is captivated with concern about the bank and sovereign debt crisis in Greece. The concern is over the terms by which it will be resolved and when. The political forces are at work, the ECB, the IMF, and the US Fed are all applying pressure. The Financial Times describes the situation as "A Defining Moment for Greek Debt". A play on words since the article is about the definitions given to what everyone perceives to be a 'credit event' in Greek sovereign debt, involving credit default swaps. Eurozone forces feel the resolution is to deepen the austerity of the Greeks putting the problem on the back of labor as well as insisting that the government sell prime assets, such as state owned transportation and valuable land assets. Bloomberg describes the situation here. The proposals are being met with resistance from Greek labor unions. It remains to be seen how the government decides what to vote. Will they shun the political force representing the banking/eurozone interests or will they adopt an Iceland type reform to protect their assets from fire sale and force losses on the financial system. If they choose the latter, the potential exists for wide ranging credit related losses for European banks and possibly other money center banks around the world too.

The US Fed has announced they do plan to end QE2 as planned at the end of June. Until then, they are still in the markets supporting asset prices. A widely held view, that I share, is that there will be some form of market manipulation choreographed by the Fed until they get enough political support for the next QE. It will take a good financial scare to move the political will, so this is the time to be patient, waiting to take on risk. John Hussman writes that more QE will be politically aggressive in the face of a discouraged populace and critical global community. In addition, the lack of evidence that QE has been successful would support its abandonment. But the final decision likely revolves around the determination of Fed Chairman Bernanke to maintain the practice.

One Eye on The Fed and the Other on the Yen

All eyes have been focused on The Fed and its various messages over the past several months. The FOMC met this week and said very little to change the expectation they have created for maintaining an easy money policy. Here is part of a FOMC Meeting Summary provided by Econoday.

Also reflecting a marginal upgrade to the recovery, the Fed dropped language regarding progress on unemployment as "disappointingly slow."

The FOMC decided to continue with its plans for QE2.

"To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."

Most likely, the next (or even current) true debate at the Fed is what to do and when after QE2 concludes at the end of June. The Fed's balance sheet will top out at a little under $3 trillion and as soon as the Fed stops making additional purchases, the balance sheet will start to unwind on its own as securities mature and/or are paid down. So, the next key question is how fast does the Fed allow the unwinding to occur? The Fed may have to reinvest some pay down to keep the decline in assets at the desired pace. The next question is if this occurs, is it still QE2 or QE2.1 or QE3?

In addition, the natural disaster and follow on nuclear crisis in Japan is inspiring unexpected developments in the yen foreign exchange. As illustrated below, the yen has strengthened substantially today, in addition to the recent upward trend since the 11th of March when life turned upside down for much of Tokyo and northern Japan. A strong yen will slow exports and tourism while adding yield to government debt. The immediate issue will be the potential unwind of the yen carry. People who have borrowed at low rates in the yen are faced with suddenly more expensive costs and those will get resolved quickly. Tomorrow could be a big day down for the developed markets.

March 17, 2011: Peter Boockvar had this comment this morning. He was using a USD/Yen chart for reference. The chart below is a Yen/USD chart. "Overnight, the Nikkei started to bounce off its lows just 17 minutes into their day (still closed lower by 1.4%) and as it steadily recovered most of its losses, the S&P futures rallied too. The yen continues to rip higher vs the US$ as the repatriation process continues but is 2 yen off its overnight highs. Let’s hope we get facts from authorities today on what is going on rather than opinions of nuclear chief’s outside of Japan"

Individual Currency Charts Replace the DXY Chart

The DXY index represents a bucket of six currencies weighted as follows... the Euro 57.6%, Yen 13.6%, Sterling 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2%, and Swiss Franc 3.6%. This design was created by J.P. Morgan in 1973.