FOMC Interest Rates and Their Impact on the US Economy: Part 2
To me, interest rates and their future direction seems to be obsessively discussed and debated by many investors. So much so, that I often get the impression that many investors believe that interest rates coupled with Federal Reserve policy are the primary drivers of our economy. From my perspective, interest rates and Federal Reserve monetary policy are contributing factors to economic growth and stability. However, I would stop short of considering them of primary importance.
The Most Important Factors of Economic Strength
The true strength of an economy is fundamentally related to its capacity to produce sufficient goods and services in order to meet the needs and wants of its people. Strong economies are highly productive, and production is the true source of wealth. In order for an economy to be productive it must possess the resources required to produce goods and services. In economic terms these are referred to as factors of production. Under modern economic theory there are four factors of production, they are land, labor, capital and entrepreneurship.
Importantly, the reader should notice that money is not included in that list. Money is simply a medium of exchange, and as such, it has no intrinsic value in its own right. Its only value comes from the product (goods and services) that buyers or sellers are willing to accept in exchange for the goods and services they want or are offering. There is an excellent series on the Federal Reserve Bank of St. Louis website titled “Economic Lowdown Podcast Series” that I highly recommend to readers interested in learning more about how the economy works. Here’s an excerpt from Episode 2-Factors of Production:
“You will notice that I did not include money as a factor of production. You might ask, isn’t money a type of capital? Money is not capital as economists define capital because it is not a productive resource. While money can be used to buy capital, it is the capital good (things such as machinery and tools) that is used to produce goods and services. When was the last time you saw a carpenter pounding a nail with a five dollar bill or a warehouse foreman lifting a pallet with a 20 dollar bill? Money merely facilitates trade, but it is
Apparently, both parties have platform planks calling for the reinstatement of the Glass-Steagall Act of 1933, the law that separated investment banking from commercial banking until it was finally repealed in 1999 (after being watered down by the Federal Reserve beginning in the late 1980s). Bringing back Glass-Steagall in some form would force megabanks like JPMorgan Chase, Citigroup, and Bank of America to split up; it would also force Goldman Sachs to get rid of the retail banking operations it started in a bid to get access to cheap deposits.
In his article discussing this possibility, Andrew Ross Sorkin of the Times slips in this:
“Whether reinstating the law is good idea or not, the short-term implications are decidedly negative: It would most likely mean a loss of jobs as part of a slowdown in lending from the biggest banks.”
I looked down to the next paragraph for the explanation, but he had already moved on to another unsubstantiated claim (that the U.S. banking industry would be at a competitive disadvantage). So, I thought, maybe it’s so obvious that Glass-Steagall would reduce lending that Sorkin didn’t think it was worth explaining. I thought about that for a while. I couldn’t see it.
In fact, basic intuitions about finance indicate that Glass-Steagall should have no effect on lending whatsoever. Banks should loan money to borrowers who are good risks: that is, those who pay an interest rate that more than compensates for the risk of default. (I’m simplifying a bit, but the details aren’t relevant.) Common sense tells you that whether the bank doing the lending is affiliated with an investment bank shouldn’t make a difference.
To dig a little deeper, banks should be making loans whose expected returns exceed the appropriate cost of capital. So, maybe Sorkin thinks that grafting an investment bank onto a commercial bank will lower its cost of capital. I can’t think of any obvious reason why this should be the case. Even if it does, however, we do NOT want the commercial bank to now start making more loans than it did before it was affiliated with the investment bank. Capital markets are supposed to direct funds to households…
In today’s FOMC Statement the Fed says the labor market has strengthened, household spending is growing strongly, and economic activity is expanding at a moderate rate.
Supposedly, “near-term risks to the economic outlook have diminished”.
But “against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.”
Stop Talking and Do It
Esther L. George, president of the Federal Reserve Bank of Kansas City dissented. She preferred to raise the target range for the federal funds rate to 1/2 to 3/4 percent today.
A key index of oil stocks continues to hold above its reclaimed 30-year old Up trendline; however, it’s been unable to mount any bounce off of it.
A lot of our very recent commentary has focused on the historically tight trading ranges in the major averages over the past few weeks. Whether they are digesting recent breakouts or merely reflecting the market’s “dog days of summer”, there has been precious little movement among the indices. One area that has taken that tight range to an extreme is the oil & gas sector. Since displaying a bit of a pop in mid-April, the sector has essentially gone nowhere for the past 3 months. Specifically, as measured by the NYSE ARCA Oil & Gas Index, or XOI, the sector has traded within a 9% range over the past 13 weeks (i.e., a full quarter). If that doesn’t seem that tight, consider that in the previous 3 quarters, the XOI averaged nearly a 7% range per week.
Now besides the dearth of action in the XOI, the other interesting aspect of the recent range is in its location. We have pointed out a few times (most recently in April) that the index’s lifetime Up trendline, stemming back to the lows in 1986, was still seemingly being respected by prices. Furthermore, this 30-year old trendline (which connects the lows in 2003 and late 2015) has appeared to delineate the safe periods in the sector from the “risk off” ones during 2016.
After breaking below the trendline for the first time ever at the beginning of the year, the XOI proceeded to plunge some 17%. However, since reclaiming the top of the trendline in mid-April (prompting our post), the index has held steady – albeit, in extremely boring fashion. Here is another look at the behavior of the XOI around its 30-year trendline.
Here is a closer look since the beginning of 2015. Note how the index continues to genuinely respect the post-1986 trendline, even after 30 years and a false breakdown.
So what’s the takeaway? That’s an easy one. First, we see good news and bad news here.
In the sound money community it’s generally understood that abandoning the last vestige of the gold standard in 1971 gave major countries effectively-unlimited credit cards – which corrupted them irredeemably.
Now – with government bonds yielding either next to or less than nothing – that corruption has begun to spread to corporations, whose bonds are being snapped up by yield-deprived investors. For example:
(Nikkei) — A shift is taking place in the Japanese stock market. Companies that take risks rather than playing it safe and transform themselves to seize growth opportunities are the new darlings among investors.
In the wake of the 2008 financial crisis, managers shunned debt. But the Bank of Japan’s “a new phase of monetary easing,” which began in the spring of 2013 was a game-changer. The BOJ’s ultraeasy monetary policy has sharply lowered borrowing costs. Among Japanese companies that have taken on more debt since the central bank’s new policy, 70% have seen their market capitalization rise.
Thus, from both a corporate and an investor perspective, debt is not necessarily a bad thing.
The positives of negative
Earlier this year, the BOJ introduced negative interest rates for the first time to try and restore the moribund economy to health. The BOJ set an interest rate of minus 0.1% for some current account deposits held by commercial financial institutions at the central bank. Under normal conditions, borrowers must pay interest rates to their creditors. Under negative interest rates, lenders, in effect, pay borrowers to take their money.
Corporate Japan is adjusting to the reality of negative interest rates. The BOJ’s below-zero rates have pushed corporate bond yields sharply lower as well. A financial subsidiary of Toyota Motor recently issued three-year bonds paying an annual interest rate of 0.001%. This translates to yearly interest of just 1,000 yen ($9.43) per 100 million yen borrowed. Many market participants believe it is only a matter of time before yields on corporate bonds slip into negative territory, just as those on government bonds have.
Hulic, a real estate company, is taking advantage of the new environment.
Wednesday afternoon, the Catalonia Parliament Approved a Track Towards Independence in open defiance of Madrid and the constitutional court.
Via translation for El pais …
The Junts pel Sí “Together for Yes” and CUP (popular unity) coalition, which has an absolute majority in the Catalonia parliament, gave parliamentary approval to the conclusions of the independence study commission.
The document outlines the steps for the “independence” of Catalonia from the rest of Spain.
The text was approved by 72 votes of the deputies Junts pel Sí Yes and CUP, but 36 deputies of Citizens (25) and PP (11) left the Chamber arguing the vote was not constitutional.
Before the vote, there was a bitter legal dispute about the legitimacy of the act.
Xavier García Albiol of the Popular Party (PP) stressed the vote was a “coup” against the Constitutional court, likening the event to the methods used in Venezuela by Nicolas Maduro.
“Separatists Gentlemen: This is an undemocratic act and outside the rule of law,” said Albiol.
Commodities will probably rebound next year as demand strengthens, according to the World Bank, adding its voice to those including Citigroup Inc. who’ve forecast that 2017 may be a better year for raw-material prices.
This afternoon Fed chair Janet Yellen will be mindlessly yapping about things like uncertainty but also about the strengthening economy. Meanwhile, today’s durable goods report should give her something to think about.
The Bloomberg Econoday consensus estimate for durable goods orders was -1.3% in a range of -3.6% to +2.0%. Orders came in at -4.0% and last month was revised from -2.2% to -2.8%.
Orders proved very weak for the factory sector for a second straight month in June, down 4.0 percent and outside Econoday’s low estimate. Core readings are also soft with ex-transportation also lower for a second month, down 0.5 percent, with core capital goods (nondefense ex-aircraft) higher but up by only 0.2 percent and following two straight prior declines of 0.5 and 0.9 percent.
Orders for civilian aircraft, which are always volatile month to month, fell nearly 60 percent in June, offsetting for the transportation group a solid 2.6 percent gain for vehicles. But vehicles are by far the best news in the report with nearly all other sectors posting declines and some sharp declines including computers, down 9.1 percent in the month, communications equipment at minus 2.3 percent, and primary metals down 1.3 percent.
Total unfilled orders are a very serious negative, down 0.9 percent following no change in May and suggesting that factories have been keeping production up by working off backlogs which is a negative for future employment. And factories did keep busy in the month as indicated by the previously released industrial production report and by a 0.4 percent gain for shipments in this report. A plus for employment is another draw in inventories, down 0.2 percent and taking the stock-to-sales ratio down to 1.64 from 1.65.
Year-on-year rates reinforce the sense of weakness. Total orders are down 6.4 percent which outside of an aircraft-distorted 19 percent decline in July last year is the weakest in 4 years. Ex-transportation orders are down a year-on-year 3.6 percent with core capital goods down 3.7 percent which, strikingly, is the 17th decline in 18 months — confirmation of weakness in both domestic and global business investment. Shipments of capital goods, which are inputs into the nonresidential fixed investment component of GDP, fell 0.4 percent in June which is a second straight decrease and will not be raising estimates for
Schizophrenic Disconnect From Reality, Bipolar Mania, Psychotic Delusions of Wealth
What diagnosis would an experienced psychiatrist offer when presented with the bizarre behavior of the U.S. stock market? We assume that the wild mood swings of greed and fear are "normal" for markets devoted to short-term profit and speculation, but the stock market's disconnect from reality is far beyond mere mood swings.
The stock market thinks it's solidly on pavement, but in reality it's like a car flying off a cliff: the Wiley E. Coyote moment is just ahead. There's nothing but air beneath the stock market.
Consider the reality of PE expansion from a price-earnings (PE) of 10 at the bottom in 2009 to 18+ today, while profits are stagnant. And what is driving this expansion other than a delusional belief that profits will magically reverse and log massive gains in the second half of 2016?
If we strip out "one-time expenses" and other accounting flim-flam, profits are plummeting. How else can we characterize this disconnect between stagnant sales (look at Apple, CAT, etc.) and "profits" that are one step away from outright fraud as anything other than delusional?
As global trade, U.S. rail traffic and other non-gameable measures of economic activity stagnate or decline, how can anyone connected to reality expect sales and profits to rise sharply?
The stock market is hitting new highs for what reason? The typical answer is: more central bank stimulus is on the way, the Fed/ BoJ /Bank of China/ European Central Bank have our back, etc. etc. etc.
But the reality is obvious to all: the returns on central bank stimulus have declined to near-zero. Trillions in additional stimulus are needed to just keep the delusional markets from experiencing gravity (see car photo above).
And how about the manic mood swings from panic in February (i.e. a whiff of reality) and the euphoria of new highs in summer? If this isn't the acme of bipolar delusion, then what is?
Perhaps the greatest delusion is the confidence that this ephemeral bubble "wealth" is actual wealth that can be counted on to fund pensions and insurance claims in the future. Pity the deranged souls who actually believe
Here’s LPL Research’s Burt White and Jeffrey Buchbinder with an important breakout not many people are discussing – US economic data is now surprising to the upside, after a year and a half of negatively-skewed reports…
The Citigroup Economic Surprise Index, or CESI, tracks how economic data are faring relative to expectations. The index rises when economic data exceed economists’ consensus estimates and falls when data come in below estimates. After an 18-month stay in negative territory, the July 8, 2016 reading put the index above zero [Figure 1]. Economic growth has not picked up during this time period but the data have been better than expected, supporting stocks during their recent ascent—including the month since the Brex...
Regional manufacturing surveys are a measure of local economic health and are used as a representative for the larger national manufacturing health. They have been used as a signal for business uncertainty and economic activity as a whole. Manufacturing makes up 12% of the country's GDP.
The other 6 Federal Reserve Districts do not publish manufacturing data. For these, the ...
By Jacob Wolinsky. Originally published at ValueWalk.
NetSuite Inc (NYSE:N) is soaring this morning as Oracle Corporation (NASDAQ:ORCL) has made a bid to buy the company for $9.3 billion. This deal has been rumored for some time but obviously few expected such a large premium or did not think the bid was certaintly coming as the stock is up about 18 percent at the time of this writing which is a lot for a tech giant. Here is what the sell side is saying.
NetSuite – analysts react
Should the transaction take place, Oracle would pay about 9x NTM EV / revenue (based on consensus estimates for NetSuite), above the average multiple paid in our precedent SaaS Software acquisitions analysis of 6.8x . Additionally, Oracl...
The following are the M&A deals, rumors and chatter circulating on Wall Street for Wednesday July 27, 2016:
Sequenom Being Acquired by Lab Corp for $2.40/Share in Cash
Laboratory Corporation of America Holdings (NYSE: LH) and Sequenom, Inc. (NASDAQ: SQNM) announced Wednesday, that they have entered into a definitive agreement aunder which LabCorp would acquire all of the outstanding shares of Sequenom in a cash tender offer for $2.40 per share, for an equity value of $302 million.
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After a three-year bull run that more than quadrupled its value by its peak last July, IBD’s Medical-Biomed/Biotech Industry Group plunged 50% by early February, hurt by backlashes against high drug prices and mergers that seek to lower corporate taxes.
This is a non-trading topic, but I wanted to post it during trading hours so as many eyes can see it as possible. Feel free to contact me directly at email@example.com with any questions.
Last fall there was some discussion on the PSW board regarding setting up a YouCaring donation page for a PSW member, Shadowfax. Since then, we have been looking into ways to help get him additional medical services and to pay down his medical debts. After following those leads, we are ready to move ahead with the YouCaring site. (Link is posted below.) Any help you can give will be greatly appreciated; not only to help aid in his medical bill debt, but to also show what a great community this group is.
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