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Wednesday, September 18, 2013 – Surprise, Surprise, Surprise

Surprise, Surprise, Surprise
by Sinclair Noe

DOW + 147 = 15,676
SPX + 20 = 1725
NAS + 37 = 3783
10 YR YLD – .16 = 2.68%
OIL + .43 = 108.50
GOLD + 55.30 = 1366.30
SILV + 1.23 = 23.06
Record highs for the Dow Industrials and the S&P 500, topping the highs of August 2. Surprise, surprise, surprise.
It was not guaranteed the Fed would start to taper, but it was widely expected. We’ve talked about the reasons why the Fed might taper; the timing of the remaining FOMC meetings this year, some improvement in the economy, fear of frothy markets. Fouhgetaboutit. After two days of meetings, the FOMC decided to continue with the current quantitative easing policy of purchasing $85 billion a month in mortgage backed securities and treasuries.

The punchbowl is full and the party is still rocking. In addition to record highs for the Dow and S&P 500, we saw 5-year Treasury’s biggest yield drop since March 2009, the US dollar’s third worst day in a year, home-builders had their biggest rally since last summer, and gold had its best day since January 2009.

At least Wall Street institutions and traders love the accommodative policy and the morphine drip of free money from the Fed. So the patient is still on morphine and the reason is because of extreme weakness. The economy just isn’t strong enough to survive on its own.

The stock market no longer rallies to the tune of increased retail sales, growing export markets or improved employment expectations, better durable goods orders and such. Good economic news is bad news for the markets because the Wall Street crowd and any investors still playing equities understand full well that any sign of fiscal improvement might mean the end of the private Federal Reserve’s morphine drip. And without the Fed’s artificial stimulus, the financial markets curls up and dies, but of course they’ll wipe out your 401k when they go. Wall Street can rally on news the Fed is continuing QE, but the broader economy was never invited to the party.

For the third time this year the central bank cut its forecast for US economic growth in 2013. The Fed now sees the economy growing in a range of 2.0% to 2.3%. Earlier forecasts had predicted growth of 2.3% to 2.6% and 2.3% to 2.8%. Being wrong is nothing new for the Fed. The bank has repeatedly offered forecasts over the past few years that turned out to be way too rosy.
Some other observations noted in the FOMC statement today: the unemployment rate remains elevated, mortgage rates have risen, fiscal policy is restraining economic growth, inflation is less than expected, and the economy just hasn’t picked up steam.
What they didn’t specifically talk about was the frothy markets. The Fed plan has been to prop up the banks and the financial markets, creating a wealth effect on Wall Street, and then let the wealth trickle down to Main Street. They’ve done a nice job of creating a wealth effect on Wall Street, but there hasn’t been any trickle down; there won’t be any trickle down, and once again the Fed is looking like they’ve painted themselves into a corner with no exit.
By postponing the decision to October or even December or whenever, the FOMC may be setting the market up for an even larger correction when it finally bites the bullet. Every time the Fed has phased out one of its stimulus programs over the last few years, stocks have dropped; first in early 2010, with the winding down of QE1; then in spring 2011, when QE2 ended, and finally in 2012 with the end of Operation Twist. In fact, stocks rallied again only when the Fed announced or started a new round of stimulus.
And there are other considerations: The German election will come this weekend; the Syrian situation looks to be moving toward a solution that doesn’t include military intervention although it is still full of obstacles.
Then we face those fiscal policy concerns; what could be some bruising budget battles as hard-line House Republicans vow to either shut down the government or not extend the debt ceiling unless Obamacare is defunded. It won’t be defunded, and even the Wall Street Journal is calling the shutdown idea kamikaze missions.
Democrats and Republicans are far apart on spending issues. More important, perhaps, Republicans continue to insist they won’t continue funding government operations—or, when the time comes, increase the Treasury Department’s borrowing authority—until Democrats agree to defund or delay Obamacare. That’s simply not going to happen. No, this isn’t the first fiscal policy standoff of the Obama presidency. In the past, Democrats and Republicans always reached some last-minute agreement. This time each side has a lot less incentive to compromise. And there are apparently no backroom negotiations; there are no calls to dine with the opposition; there is no discussion going on at all at this point.  
What makes this time is different is that, in addition to having carved out hardline positions, neither side has an incentive to back down. In 2011, Obama was willing to give on his demand that revenue increases accompany spending cuts because he understood the apocalyptic consequences of failing to raise the debt ceiling. In late 2012, Republicans knew that the alternative to a small tax increase was for taxes to rise automatically by a much larger amount. The sequester, although unsatisfactory to both sides, was a built-in default position; and indeed that’s what happened. This time, on the other hand, every party to the negotiation has reason to welcome the government shutdown that would result if they can’t reach a deal.
Start with the White House, which has been annoyingly open to concessions even when it has all the leverage. Now they are finding no constituency for caving. Add in that the elections have passed and lame ducks find it easier to grow a spine when they don’t have to beg for campaign contributions. You can’t rule out the possibility that the White House will blink when the deadline gets close. At the very least, one can imagine Obama signing a short-term government funding measure (known as a continuing resolution) that leaves the automatic sequester cuts in place so long as it doesn’t touch Obamacare. Even if he were inclined to do this, Congressional Democrats seem less willing to support him than in the past. They believe they can demand much more in exchange for saving the GOP from a shutdown.
For the Tea Partiers, a shutdown would mean they forced their leadership to stand up to Obama, which plays well in their districts and the various organs of the conservative movement. And when the GOP inevitably bowed to public opinion and sued for peace, the Tea Partiers would be able to accuse their weak-kneed leadership of caving, thereby enhancing their status within the party, and greatly enhancing contributions.
Then you’ve got the old line GOP as represented by Speaker Boehner and McConnell from the Senate; they can’t control the Tea Partiers, and it appears they will accept a government shutdown because they can’t stop it. A shutdown would slow the economy and wreak havoc on people who rely on government services, and wreak havoc on companies that service the government and the people who receive government services, and there will be a massive fallout.
These consequences are nothing alongside the fallout from defaulting on our debt, which will happen if we don’t raise the debt ceiling by mid-October.So a government shutdown gives everyone a chance to sober up before we take on the substantially higher-stakes proposition of avoiding a debt default.
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