Financial Review

Have a Cigar

Financial Review by Sinclair Noe

DOW + 288 = 17,356
SPX + 40 = 2012
NAS + 96 = 4644
10 YR YLD + .08 = 2.15%
OIL + .06 = 55.94
GOLD – 6.10 = 1189.90
SILV + .03 = 15.85

I have been telling you for a few years now that the Fed is a vital force in the stock market. I have talked about how the stock market has advanced along with the Fed’s balance sheet. Today absolutely confirms what I’ve been telling you.

Most major indices started the day a little higher, and then jumped following the Fed’s FOMC statement and again during Chairwoman Janet Yellen’s press conference. At one point the Dow Industrial Average was up about 300 points; and then people started to digest what was being said; which is what we will do right now.

The Federal Reserve indicated it was moving closer to raising interest rates from record-low levels because the economy and job market are getting stronger. The Fed also promised to take a “patient” approach in doing so, which sounded very reassuring investors; it sounded like the Fed wouldn’t tighten credit too soon and endanger the economic recovery; they won’t surprise us or rush to tighten next year. The Fed kept the phrase “considerable time” and then they added that they will be “patient”, which really did not help to provide clarity or precision.

Yellen’s press conference covered a range of topics. She said a short period of very low unemployment will help get inflation back to target. And we may be closer to the inflation target than we think because market-based expectations for inflation can’t be entirely trusted to give clear signals. The drop in the market’s expectations for inflation could also reflect other factors, such as the flight to safety into Treasuries. The Fed puts more weight on survey-based measures derived from consumers’ expectations and economists’ forecasts.

This morning before the Fed statement we had a report on inflation. The consumer price index fell by a seasonally adjusted 0.3% last month to mark the largest drop since December 2008. Energy costs fell for the fifth straight month, led by a 6.6% decline in the price of gasoline. The cost of food rose just 0.2% in November. And for people who don’t drive or eat food they strip out volatile food and energy costs, so-called core inflation edged up 0.1% last month. The pace of inflation over the past 12 months fell to 1.3% in November and is down sharply from 2.1% just five months ago. Real hourly wages are up just 0.8% in the past 12 months, so there is really no inflationary pressure from wages.

But the Fed doesn’t seem concerned about low-flation. The plunge in oil prices is a plus for the economy and will have only a transitory impact on inflation. Their thinking is that they are on track for their inflation target of 2%, more or less, give or take. Maybe. Except it isn’t happening now. In fact, 2014 will mark the first time in at least 55 years, not one advanced economy will see consumer prices growing more than 4% this year. But the Fed isn’t particularly worried about weakness in the global economy or low oil prices or the meltdown in Russia; they are aware and monitoring but not very concerned.

The Fed will raise rates at some point, probably. Keep in mind that Ben Bernanke talked about raising rates, but he never quite got around to it. But Yellen’s Fed will be raising rates, but they will be patient. The first rate hike won’t come for at least “a couple of meetings.” And “a couple means two.” So, that sounds like a rate hike in March, but Yellen says more likely before the summertime, but that’s not a promise or commitment; more like a qualified maybe.

Raising rates too quickly could increase lowflationary pressures. And it could doom millions of workers to subpar incomes, unemployment or underemployment. Raising rates too slowly could theoretically increase inflationary pressures, but the real danger in the mind of the Fed is that low rates encourage risky financial behavior, the kind of risky behavior that led to the last couple boom-and-bust cycles. It’s not just the departure date that matters, Yellen says. The pace of subsequent rate hikes is what is important. And that will depend on the data.

And after all the tap dancing was over we were back where we started, which is the idea that the Fed will start to raise rates around June as long as the economy continues to improve pretty much as expected and nothing collapses unexpectedly. More or less.

Now, since the press conference I’ve been reading about Yellen’s performance and it is easy proclaim the Fed is wishy washy or uncertain or guessing. But if you have been following the Fed for a long time, and I have, this is just standard operating procedure. When Yellen says a hike could happen in a “couple of meetings” it is a trial balloon. When they add language about being “patient” they are testing the markets while trying to be reassuring. One thing the Fed has learned is not to make sudden movements; it did not work well in 2008; it did not work well in 1987. And it does not look like there will be any sudden movements in the foreseeable future.


Treasuries declined after the Fed statement. The stock market moved higher. Enjoy. Have a cigar. Not some beat up old stogie but a real cigar, a Cuban. Actually, you can’t do that today, but maybe soon. President Obama and Cuban President Raul Castro announced today they would begin normalizing relations between the two nations, as art of a deal brokered by Pope Francis. The pope played a key role in the talks, sending a letter to Castro and Obama urging them to resolve the dispute over Gross and pursue closer relations. The request from the Pope was rare and came shortly after a meeting Obama had with Francis at the Vatican earlier this year.

The action means not simply the opening of a US embassy in Havana but the lifting of some of the restrictions that have limited travel and commerce and kept aficionados from legally bringing Cuban cigars to US soil.

The announcement was wrapped into the release of American aid worker Alan Gross and the exchange of a US spy for three Cuban intelligence agents. Obama and Castro made simultaneous announcements in Washington and Havana to outline the rapprochement. The US will issue regulations within weeks and will open an embassy as soon as logistically possible. Obama said he would engage Congress “in an honest and serious debate” about changing legislation to fully end the US embargo of Cuba. Some legislators have already vowed to block any change in legislation.

If it goes through, US companies will be permitted to export to Cuba telecommunications equipment, agricultural commodities, construction supplies and materials for small businesses. US financial institutions will be allowed to open accounts with Cuban banks. Exports will mainly be permitted to Cuba’s emerging private sector, including residential goods and equipment for small businesses and agriculture; and there will be some travel permitted for US citizens, but not for tourism. Limits on Cuban-Americans’ remittances to relatives in their homeland will jump to $8,000 from $2,000 annually.

Why, after more than 50 years, did a breakthrough in Cuban-American relations happen now? There are many reasons, but one factor is oil. Cuba has been getting about 100,000 barrels of oil per day from Venezuela in exchange for medical personnel. The collapse in oil prices now leaves Venezuela’s economy in terrible shape with the world’s fastest inflation and the country’s bonds on the verge of default. The country faces a 60 percent chance of defaulting on its foreign debt in the second half of next year if oil prices do not recover. Cuba recognized that it was very risky to be overly dependent on Venezuela. Cuba was well aware of the risks of dependency after the economy collapsed in the early 1990s when the Soviet Union collapsed.

Cuba and Venezuela are not the only countries facing problems from low oil prices. Russia of course – we talked about that yesterday. Tomorrow Putin will talk about it. The Russian president will face questions from the media at his annual press conference. Whether a few words from Putin will restore the status of Russian stocks and the ruble remains to be seen.

On December 8th Moody’s gave 6 Middle Eastern countries a thumbs up based on the assumption that oil prices will average $80 to $85 a barrel in 2015. That assumption now seems suspect. Yesterday, oil prices briefly dipped down around $53 a barrel; today crude for January delivery was down as low as $54.21. While Gulf states can make some spending cuts, they’ll need to do more to cover likely shortfalls. The states with bigger sovereign wealth funds will tap them as needed. The ones with weaker positions will borrow. Many of these oil producing countries run sovereign wealth funds which are largely funded by oil. They are pretty certain not to be making new investments and are likely to be making some sales. Not only will their sales have some impact at the margin, but their absence as deep pocket opportunists could be more important than one might imagine. Recall that in the early stages of the financial crisis, sovereign wealth funds stepped up to provide capital to quite a few wobbly banks. There will be fewer to act as rescuers this time around. And sovereign wealth funds are also big investors in private equity.

Greece moved a step closer to early elections after Prime Minister Antonis Samaras failed to gather enough support for his nominee in a parliamentary vote for a new head of state. Samaras got 160 of the 300 votes but needed a two-thirds majority. There will be another vote December 23rd, and if that fails, a third vote on December 29 with a 180 vote threshold, and if that fails the parliament will be dissolved and early elections will be called.

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