Financial Review

Incredibly Orwellian Record High

Financial Review

DOW + 24 = 17,156
SPX + 2 = 2001
NAS + 9 = 4562
10 YR YLD + .01 = 2.60%
OIL – .90 = 93.98
GOLD – 11.70 = 1224.20
SILV – .16 = 18.62

The Dow Jones Industrial Average closed at a record high of 17,156.85; the first record high for the Dow since July. The Dow set an all-time intraday high of 17,221.11. It was the sixteenth record close for the blue chip index in 2014. The stock market action today was focused on the Federal Reserve. I suppose we could say the same thing about the past 6 years.

Today, the Federal Reserve wrapped up its FOMC meeting. The FOMC stands for Federal Open Market Committee, which sounds incredibly Orwellian. The meeting was a rousing success; we know this because the media coverage can’t quite figure out whether the Fed will raise interest rates sooner or later, or whether the economy is weaker or stronger.
While the much analyzed phrase “considerable time” remained in the FOMC statement, the newly announced scheme for interest rate normalization shows that higher rates are in the cards. The FOMC also said labor market conditions improved but a significant amount of slack remains.

The Fed said it would end the bond-buying program known as quantitative easing in October. The Fed will purchase $15 billion of mortgage and Treasury bonds in October and then make no purchases in November. The Fed shared some details of its exit strategy, which clearly indicate they are preparing to raise rates at some point in the future, but Yellen stressed in her news conference that the exit plan “is in no way intended to signal a change in the stance of monetary policy.”

The Fed updated their economic growth forecasts, revising lower; they now say they expected the economy to grow between 2% and 2.2% this year, between 2.6% and 3% in 2015, between 2.6% and 2.9% in 2016 and between 2.3% and 2.5% in 2017. Most Fed officials continue to expect the central bank to first increase interest rates at some time next year. In the forecast, 14 of 17 officials said they continue to believe the Fed’s first increase in near zero short-term rates will occur in 2015. One official believes the Fed should boost rates this year, while two think the central bank can hold off until 2016.

Fed officials raised their median estimate for the federal funds rate at the end of 2015 to 1.375 percent, compared with 1.125 percent in June. And that sounds like fairly aggressive tightening, but they say the rate guidance is “highly conditional” and remains linked to conditions in the economy. So, you combine aggressive tightening with downward revisions to GDP for the next couple of years, and where exactly does that leave you?

Treasuries fell and the dollar gained. The dollar has been on a tear lately.

Consumer prices fell in August for the first time in 16 months as gasoline prices fell. The consumer price index dropped 0.2% after rising 0.1% in June. In the past 12 months, prices have risen 1.7%. Excluding volatile food and energy costs, price were unchanged, the first time so-called core prices have not increased since October 2010. Core prices are up 1.7% the past year.

In August, energy costs fell by 2.6% to mark the largest decline in 17 months. Lower gasoline prices led the way. The price at the pump has been retreating since midsummer and might fall further in the months ahead. Natural gas also decreased for the fourth month in a row. Food costs rose 0.2%. Beef prices jumped 4.2% to mark the biggest increase in almost 11 years. Beef prices have been surging because the US cattle herd is at its thinnest level in decades. It could take several years to build back up. The cost of housing rose again while alcoholic beverages and new cars also increased in price. Airline tickets, clothing, household furnishings and used vehicles declined. And medical costs were flat. Real wages are only up 0.4% in the past 12 months, but lower inflation gives households a short-term boost by stretching how far their paychecks will go. Real or inflation-adjusted hourly wages jumped 0.4% last month, the biggest gain since late 2012; but that’s because inflation is low, not because wages are higher.

The NAHB/Wells Fargo Housing Market index rose to 59 in September from 55 in August; the index measures sentiment of homebuilders. It was the fourth straight monthly gain following a lengthy slump in builder sentiment through most of the first half of the year.

The Commerce Department said the current account gap, which measures the flow of goods, services and investments into and out of the country, fell to $98 billion in the second quarter from a revised $102 billion shortfall in the first quarter. The current account deficit has been gradually shrinking, hitting a 14-year low in the fourth quarter of 2013, helped in part by declining petroleum imports as the nation reduces its dependency on foreign oil.

The International Monetary Fund says the global economy faces a growing risk from big financial market bets that could quickly unravel if investors get spooked by geopolitical tensions or a shift in US interest rate policy. The IMF also warned that financial market indicators suggested investor bets funded with borrowed money looked “excessive”.

I don’t think the IMF is just looking at margin debt for Mom and Pop investors. Sales of subprime mortgage bonds have withered since the financial crisis, but fresh concerns are arising as issuance of some other types of securitizations surge. Sales of bonds backed by loans used to finance car purchases undertaken by the least creditworthy borrowers have reached pre-crisis levels in the US, prompting a Department of Justice investigation. While losses on subprime auto asset-backed securities (ABS) remained low during the crisis, there are concerns that new specialized lending companies are making riskier loans which are then being bundled into the bonds.

Also, according to Dealogic data, US sales of commercial mortgage-backed securities, or CMBS, have also staged a recovery with $102 billion worth of the deals sold last year, the highest amount since the $231 billion issued in 2007. At the same time, some market participants have been warning that the quality of the loans that underpin the bonds – typically secured by shopping malls, office buildings and other commercial properties – has been slipping.

And even when the investor bets aren’t funded with “borrowed” money, the bets can look a bit excessive. Bill Gross, the co-founder of Pacific Investment Management Co., sold most of the $48 billion of US Treasuries held by his $221 billion Pimco Total Return Fund in the second quarter, replacing them with about $45 billion of futures. The contracts require small up-front payments, freeing up money for Gross to invest in higher-yielding securities including Brazilian, Spanish and Italian debt. They are taking the cash and buying all these peripheral bonds that have a lot of spread on them relative to Treasuries; this is apparently the new trend that is occurring across the money-management industry.

And the Wall Street debt underwriters are now pitching the idea of the “mega-deal”. With investors clamoring for higher-yielding assets and companies on the biggest acquisition spree since 2007, bankers are talking up the ability of credit markets to fund really, really big acquisitions, even those looking for $100 billion or more of financing. That’s stoking speculation debt investors stand ready to fund potential takeovers such as a purchase by Anheuser-Busch InBev of rival beermaker SABMiller. And this even as investors brace for the 30-year rally in bonds to come to an end. The bankers are flush from $18 trillion in corporate bond sales globally the past six years, and I guess they need to meet their quota this year.

Investors have poured about $49 billion this year into mutual funds that buy taxable bonds after pulling $20 billion in 2013. The added cash has helped shrink the extra yield that investment-grade debt worldwide pays above government securities by 15 basis putting the spread near a seven-year low. Hmmm, what happened 7 years ago?

Meanwhile, the IMF is concerned the whole thing could unravel because of geopolitical tensions. Today, Congress gave Obama the go-ahead to arm and train Syrian rebels. The US House approved the president’s plan to send military trainers and arms to Saudi Arabia to help Syrian rebels fight the Islamic State. Republican Congressional leaders backed the legislation, despite their concerns that the administration’s response to ISIS is inadequate.

The biggest trick might be finding the right rebels to arm and train. Apparently we’re looking for moderates, in a land not known for moderation. I’m not sure having the Saudis serve as the HR department will work. In more unrelated news, the Saudis are cutting production to sustain prices above $100 a barrel; after all, the Saudis can’t be expected to do all this without compensation. In addition to the higher prices on a barrel of oil, the administration wants to put some 5,000 of these moderate, non-jihadist Free Syrian Army personnel through a training program in Saudi Arabia at a cost of about $500 million. My back of envelope calculation puts that training at about $100,000 for each moderate rebel, which brings a new Orwellian understanding of the Free Syrian Army. I just wonder if this is the best and highest use we could find for $500 million.

Meanwhile, the chairman of the Joint Chiefs of Staff, US Army general Martin Dempsey, told a Senate committee that if this approach doesn’t do the trick, he may recommend that the US send ground forces. A White House spokesman threw water on the idea, saying the US “will not deploy ground troops in a combat role into Iraq or Syria.” (Nobody had the heart to tell him about the 1600 troops already deployed to Iraq.)

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