Mish's Global Economic Trend Analysis

Quantitative Nothingness and the Yield Curve's Reaction
Small Business Trends - Yet Another Disaster
Quantitative Easing Take II; Uncharted Territory

Quantitative Nothingness and the Yield Curve's Reaction

Posted: 10 Aug 2010 06:12 PM PDT

While most eyes were focused on the FOMC meeting, I did something far more enjoyable, and probably far more sensible as well. I went golfing.

Upon return I see a new but meaningless twist in Bernanke's statements in the latest FOMC Press Release.

Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.

Quantitative Nothingness vs. Quantitative Easing

Bernanke's pledge to hold the Fed's balance sheet constant is certainly a new twist. However, given that quantitative easing will not do a damn thing as discussed in Quantitative Easing Take II; Uncharted Territory it is silly to think that Quantitative Nothingness will do anything.

When the equity market will figure this out remains a mystery, but the treasury market seems to have figured it out already.

10-Year Treasury Yield Hits 16-Month Low

If the Fed's action was supposed to help the economy grow, long-term yields actually should have bounced. Instead, they reached a new low for the move.

While some will scream manipulation, and clearly it is, the key point to remember is the Fed cannot change the trend.

Quantitative Nothingness aside (Quantitative Constancy if you prefer) treasuries were poised to rally in the face of extended economic weakness, and they did just that.

Yield Curve as of 2010-08-10

7-year Sweet Spot

Once again the yield curve flattened with the "sweet spot" this time being the 7-year treasury. The 30-year long bond barely budged.

Normally, the further out one goes the bigger the rally (or loss) in response to economic news. It will be interesting to see if the 30-year long-bond can catch up.

Yield Curve May 2008-Present

click on chart for sharper image

A couple things stand out on the above chart.

1. The 5-year treasury yield is approaching all-time record lows and is now back to where it was in January of 2009.

2. The spread between 10-year treasuries and the 30-year long bond continues to widen

I suspect a major player continues to put on a long-10 short-30 trade. I can easily be wrong on that. The question is "where does the spread go from here?"

A continued bullish flattening of the curve, with the long-bond playing catch-up is certainly not out of the question.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Small Business Trends - Yet Another Disaster

Posted: 10 Aug 2010 12:04 PM PDT

Neither the treasury market nor small business trends reflect the incessant optimism of the stock market. These will eventually align, when I do not know.

Please considerNFIB Small Business Economic Trends for August 2010.

OPTIMISM INDEX

The Index of Small Business Optimism lost 0.9 points in July following a sharp decline in June. The persistence of Index readings below 90 is unprecedented in survey history. The performance of the economy is mediocre at best, given the extent of the decline over the past two years. Pent up demand should be immense but it is not triggering a rapid pickup in economic activity. Ninety (90) percent of the decline this month resulted from deterioration in the outlook for business conditions in the next six months. Owners have no confidence that economic policies will "fix" the economy.

LABOR MARKETS

Ten (10) percent (seasonally adjusted) reported unfilled job openings, up one point from June but historically very weak. Over the next three months, nine percent plan to increase employment (down one point), and 10 percent plan to reduce their workforce (up two points), yielding a seasonally adjusted net two percent of owners planning to create new jobs, up one point from June and positive for the third time in 22 months.

CAPITAL SPENDING

The frequency of reported capital outlays over the past six months fell one point to 45 percent of all firms, one point above the 35 year record low reached most recently in December 2009. The percent of owners planning to make capital expenditures over the next few months fell one point to 18 percent, two points above the 35 year record low. Five percent characterized the current period as a good time to expand facilities, down one point. But a net negative 15 percent expect business conditions to improve over the next six months, down nine points from June and 23 points from May.

INVENTORIES AND SALES

The net percent of all owners (seasonally adjusted) reporting higher nominal sales in the past three months lost one point, falling to a net negative 16 percent, 18 points better than June 2009 but indicative of very weak customer activity. Widespread price cutting continued to contribute to reports of lower nominal sales. The net percent of owners expecting real sales gained a point over June, rising to a net negative four percent of all owners (seasonally adjusted), quite dismal.

INFLATION

The weak economy continued to put downward pressure on prices. Twelve (12) percent of the owners (down one point) reported raising average selling prices, and 24 percent reported average price reductions (down three points). Seasonally adjusted, the net percent of owners raising prices was a negative 12 percent, a two point increase in the net percent raising prices. Plans to raise prices fell one point to a net seasonally adjusted 10 percent of owners.

PROFITS AND WAGES

Reports of positive profit trends worsened by a point in July, registering a net negative 33 percentage points, 29 points worse than the best expansion reading reached in 2005. The persistence of this imbalance is bad news for the small business community. Profits are important for the support of capital spending and expansion.

CREDIT MARKETS

Regular borrowing gained three points from last months record low to 32 percent accessing capital markets at least once a quarter. A net 13 percent reported loans harder to get than in their last attempt, unchanged from June. Overall, 91 percent of the owners reported all their credit needs met or they did not want to borrow, up one point. Credit may be harder to get
compared to the bubble period (as it should be) and is always harder to arrange in a recession. But credit availability does not appear to be the cause of slow growth as many allege.

COMMENTARY

The expiration of the Bush tax program and the implementation of the health care bill represent the two largest tax increases in modern history. Add to that serious talk of a VAT and passing cap and trade. Nothing here to create optimism about the future for business owners or consumers. Top that off with government borrowing of $1.8 trillion last year and $1.5 trillion this year and on into the future, it is no surprise that owners are fearful and pessimistic.

What's missing from the "debate" is logic. Policies should not violate common sense and logic, if they do, they are misleading and disguising a hidden agenda. Arguing that more government spending and taxes are needed to re-establish optimism, confidence and growth doesn't meet the common sense test. Saving bankrupt companies to preserve union jobs doesn't make sense either. The list of these "policy inconsistencies" is long.

Bottom line, owners remain pessimistic and nothing is happening in Washington to provide encouragement. Confidence is lost.

The article sports numerous charts of trends of all the individual components. It's well worth a look.

I happen to agree with their commentary that Obama administration policies are compounding the already numerous structural underpinnings that are amazingly poor in and of themselves.

From Fooled by Stimulus - Structural Problems Still Intact.

Problems Many, Solutions Nonexistent

Tide of Debt: Consumers are swimming against a tide of debt with no way to pay it back.
Demographics: Boomers are heading into retirement scared half to death because they did not save enough.
Jobs: There is no source of jobs
Wages: Global wage arbitrage
Attitude Changes: a secular shift in the attitudes of consumers towards housing and risk taking is underway.
The Fed is powerless to change attitudes.

It is going to be extremely difficult to counteract all of the structural problems in place.

Poor policy decisions compound the problems facing small business owners. And unless small business conditions improve, business hiring plans are not going anywhere no matter how much the Fed wishes, hopes, fires bazookas, or quantitative eases.

For more on the quantitative easing debate, please see

Will Quantitative Easing Spur Inflation? Job Creation? Credit Expansion? Do Anything?

Quantitative Easing Take II; Uncharted Territory

Those expecting quantitative easing to cause massive inflation or to do much of anything at all simply are not thinking clearly.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Quantitative Easing Take II; Uncharted Territory

Posted: 10 Aug 2010 03:03 AM PDT

In response to Will Quantitative Easing Spur Inflation? Job Creation? Credit Expansion? Do Anything? (a point-by-point discussion of thoughts from Chris Ciovacco at Ciovacco Capital Management regarding quantitative easing), I received a nice reply from Chris.

Chris writes ...

Hello Mish:

I agree with your comments today. We could have done a better job properly framing our comments on quantitative easing. We added the following to the top of our review to clarify our remarks:

Our interpretation below relates to the asset markets and asset prices. We believe quantitative easing can impact asset prices in the short-to-intermediate term. We do not believe quantitative easing is the solution to the global economy's problems, nor do we believe it will create long-term prosperity or job growth.

As money managers, our job is to understand the possible impact of Fed policy on the value of our clients' investments. The short-to-intermediate-term driver of asset prices would be the perception of market participants, right or wrong, that the Fed can create positive inflation.

We firmly believe quantitative easing can impact the prices of stocks, commodities, and currencies in the short-to-intermediate term. In that light, we believe quantitative easing, or even the potential for the Fed to buy Treasury bonds, is an important factor in determining investment outcomes in the next six to twelve months. Financial market performance and the long-term economic impacts of quantitative easing are two separate issues.

Have a great weekend,

Ciovacco Capital Management
Chris Ciovacco

My Reply ...

Thanks Chris.

That is much better expressed. It is possible we are seeing some up-front effects now. If so, we could see a spike and a sell the news event, if and when the Fed does start QE2.

Moreover, this could be another "bazooka" ploy. So far all such ploys have failed. However, it is conceivable one of these bazooka plays "works" (rather appears to work), temporarily. One must balance that with the possibility QE2 blows up in the Fed's face if they try it.

This is a very difficult market to judge. I see absolutely no reason to be long here. However, that is not an endorsement to short.

Mish

Chris Responds - Deflationary Outcomes Possible:

Hi Mish:

Appreciate the feedback. These are difficult times for investors and professional asset managers. We agree QE2 could result in another speculative leg higher in the markets or it could backfire.

Your comment "this is a very difficult market to judge" is right on the money. In our view, investors must understand and respect that short-term, primarily speculatively-based, gains are possible in asset prices. However, deflationary outcomes are also possible.

Asset price deflation (stocks & commodities) could take hold near current levels or could occur after another leg higher. We see the threat of a deflationary spiral accelerating if the S&P 500 again revisits the 1,010 to 945 level.

Any sustained break of 945 could open the door to very unpleasant outcomes. I think posting the email (and your thoughts) is a good idea. As I am sure you agree, our objective is to help people understand possible outcomes, over different time horizons.

Ciovacco Capital Management
Chris Ciovacco

Inflation Threat is Congress Not the Fed

The real inflation threat in the US is not the Fed. I think the Fed is pretty much powerless here. If quantitative easing seems to work, it will be temporary, just as happened in Japan.

Many people have emailed me stating that the Fed will give away money. No the Fed won't.
The Fed cannot throw money out of helicopters or give money away. Such talk is nonsense. However, Congress can give money away.

Here are the pertinent questions:

1. How likely is that?
2. Enough to cause a serious bout of inflation?

The answer to #1 is straightforward enough: It is certain. Indeed, Congress has reluctantly agreed to toss another $26 billion at states to "save jobs". The idea is foolhardy of course. One of the big problems cities and states face is public unions and public union salaries.

Those problems wrecked Greece and in my opinion have virtually bankrupted many major cities and states. Yet, here we are making another policy error, attempting to keep union wages intact and a defined benefit pension scheme alive, both of which desperately needs to be tossed in the gutter permanently.

The more important question is #2. Most think yes. I think no.

For starters the next Congress is going to be a lot more conservative than this one. Already we have seen unemployment benefits delayed for week. Money for the states came out of another pocket so the deficit did not go up.

However, a major reason a massive helicopter drop is not coming in spite of what everyone seems to think, is neither the Fed nor banks wants one! The Fed does not want hyperinflation as it will end the game. Banks do not want hyperinflation for the same reason.

What Do Banks Want?

Leaving aside the issue of hyperinflation, a complete loss of faith in the value of currency (an idea I believe is extremely remote), does anyone benefit from strong inflation?

I do not believe banks want serious inflation for the simple reason they do not want to be paid back with inflation cheapened dollars. Banks who were bailed out by taxpayers, already got what they want. They have nothing but scorn for the average Joe on the street his problems.

Besides, rising prices is no guarantee there will be job growth.

If banks don't want it, and the Fed doesn't want it, and Congress is likely to be far more conservative, then how is it going to happen? It is possible of course, but how likely?

That was a hidden theme in Fooled by Stimulus - Structural Problems Still Intact.

Problems Many, Solutions Nonexistent

Tide of Debt: Consumers are swimming against a tide of debt with no way to pay it back.
Demographics: Boomers are heading into retirement scared half to death because they did not save enough.
Jobs: There is no source of jobs
Wages: Global wage arbitrage
Attitude Changes: a secular shift in the attitudes of consumers towards housing and risk taking is underway.
The Fed is powerless to change attitudes.

It is going to be extremely difficult to counteract all of the structural problems in place.

As long as those structural problems are in place, the most likely outcome by far is a long drawn out Japanese style malaise. Whether or not prices as measured by the CPI stay above the zero line or dip below is actually a fairly insignificant point.

Bank lending and job creation are what matters most. The Fed is powerless on both of those scores, and barring massive efforts by Congress (and probably even with massive efforts by Congress), job creation is not around the corner.

Here is the essential question: If $1 trillion in fiscal stimulus did next to nothing, pray tell why would another trillion do anything?

Is another $trillion in fiscal stimulus coming? I highly doubt that.

Might a $trillion in QE2 come? Sure, perhaps even double that. But would it accomplish anything?

Long-term Chris Ciovacco agrees that it will not spur growth or fix any structural problems.

Short-term is more debatable, but perhaps the only response is a move in treasuries or gold.

Shorting Treasuries

Many have gotten their heads blown off again shorting treasuries. With all the above-mentioned structural issues, and with the Fed threatening QE2 on top of it, why would one want to be short treasuries here?

Fed Cannot Change the Trend

Let's return to the revised thesis, that QE2 may cause a bounce in the markets. Chris believes "quantitative easing can impact the prices of stocks, commodities, and currencies in the short-to-intermediate term."

While possible, please remember ...

The Fed can speed up or delay, but not change the primary trend.

Quantitative easing might give a boost to that downward trend in 10-year treasuries, but Fed purchases of treasuries is certainly is not the cause of plunge in 10-year treasury yields. The slumping economy and deflation are the cause.

Fundamentally, yields ought to be falling, and they are. If and when yields are poised to rise, the Fed will not be able to do much to stop it.

Perhaps QE2 causes a bounce in the equity markets, but it will quickly fade unless the market was ready to head in that direction permanently.

Uncharted Territory

To be sure, we are in uncharted territory, not only in treasuries, but in the Fed's response to the crisis. I called for the Fed's power grab and willingness to break rules in advance on April 3, 2008 in the Fed Uncertainty Principle.

Nonetheless, I do not know for sure what is coming up next. No one else does either. Yet I see statements every day on the internet such as "I know gold is headed to $2000", "The bottom is in", etc.

Well gold may (or may not) hit $2000 but certainly no one knows. It may also fall to $500. The Bottom in the stock market may be in, but there is a very good chance it isn't.

The Known

1. Structural problems (tide of debt, demographics, etc - as noted above) are numerous.

2. Stocks are not cheap if you factor in quality of earnings, dividends, historical PEs, etc. Stocks only "appear" cheap if you believe forward earnings estimates in the face of those structural problems.

3. Buying stocks in the face of such structural issues, at a time when they are not cheap is highly likely to yield poor results.

4. It is difficult if not impossible to time the effect (if any) of quantitative easing. In fact, we may have already seen it in advance.

5. Gold is in a long-term bull market with its monthly trendlines intact. Other than treasuries, not much if anything else is.

Some may debate point number two, but I am willing to state that is what I know. However, knowing stocks are not cheap, and knowing where they are headed are two entirely different things.

The Unknown

We do not know what Congress will do, what the Fed will do, or what foreign central banks will do if the economy heads south again in a major way. We have ideas, but we cannot say we know.

Moreover, it is not what the Fed or Congress does in isolation that will matter most, rather what they do in relation to what other countries is what matters, and we certainly do not know that.

China is a wildcard and its response to the next global slowdown will greatly impact commodities. Does anyone know for sure what China will do? I think not.

The Mideast is another wildcard. Certainly we might see a startling reaction if Israel were to attack Iran or vice versa.

The Odds

While stocks may rise in this environment, the odds are they don't. While treasury yields may shoot to the moon, the odds are they won't. While gold may collapse, the odds are it won't.
While quantitative easing (assuming it happens) may temporarily effect stock prices favorably, the odds are against someone timing it correctly.

This is is not a call for anyone to short this market as most of those structural problems are reasonably well understood. However, this is quite a good time to be thinking about risk-reward setups, because the odds of a sustained rally sure do not look favorable.

Bear in mind unfavorable and impossible are not the same thing. While one might throw sevens, four times in a row at craps, I would not advise betting on it.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

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Mish's Global Economic Trend Analysis

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