Tuesday, August 10, 2010

Expect Deflation As Deleveraging Is The Primary Theme

The 8:30am 2nd Quarter Non-Farm Productivity numbers came out and they were far weaker than expected. Productivity came in at -0.9% against the consensus estimates of a gain of 0.3%. Unit labor came in at 0.2% vs the consensus of 0.5%. Unit labor cost figures are closely watched by the Fed for clues for inflation. The higher the figure the higher levels of expected inflation. The grand plan that was laid out for the sheep was that stimulus was going to re inflate prices and ignite animal spirits. That clearly has failed as these figures show deflation which only really means deleveraging.

What all this means for the Fed and their actions today is anybody's guess. Does the Fed admit their gross negligence and incompetence and resume for QE? This is what the market has anticipated for the last week, all along just ignoring negative data points about the economy. Friday's claw back from steep losses on the backs of a brutal NFP report and yesterdays continued rally were built on the hopes that the Fed would do the all or some of the following:

1- Resume buying assets via investments in Treasuries.
2 -Reduce interest rates on excess reserves
3- Further signal that ZIRP would be the benchmark Fed Policy for the foreseeable future.
4- Coordinated effort with Treasury on Mortgage Refinance Program

WOW...That is a lot for the Fed to do. Will they do any of this? Some? I personally think they will NOT start buying Treasuries from the MBS proceeds that are carried on their balance sheet. There will be no interest rate reduction on excess reserves. ZIRP is the benchmark policy for the next 10 years, and any mortgage refi program is not happening at this moment. This is a politically charged issue and will be unveiled near the mid term elections.

All in all its going to be a non event and a non event is going to be disastrous for risk assets, as any non action by the Fed will have the USD rallying. When the USD rallies, liquidity is taken out of the system, thus risk assets are sold. Treasury prices most probably just go sideways as most are buying Treasuries because they fear deflation and risk aversion, not because the Fed is rumored to buy.

There are many on Wall Street that think the economic outlook has not deteriorated enough to warrant more action, but many on Wall Street are dolts who never predicted the recession so they cant be taken seriously. The economy is headed into a double dip, housing is about to roll over, labor market momentum has slowed, and consumer confidence continues to be weak. The economy is in the crapper but the stock market has been very strong because surprise! its disconnected from the realities of the economy. The HFT machines know that there is a Bernanke "PUT" and a Plunge Protection Team ready to stoke the fires and soak up the sellers.

Given that the Fed has limited options now that short term interest rates are already close to zero, I am thinking the fed probably will want to keep the little ammunition that they have left. What the Fed should have done late last year or early this year when the economy was clearly in better shape was to raise interest rates ever so slightly. This would have given the Fed some room to ease policy. At the moment the Fed is a turbo charged political entity that is walking on egg shells. I can assume that if the Fed raised interest rates and the economy sank, they would have been blamed for the economy sinking. Again, its the job of the Fed to be completely independent and be indifferent to politics. The Fed is now rendered impotent to their own policies. Taking any additional stimulus measures would make the Fed lose whatever credibility that they have because it would signal a loss in confidence in its most recent forecasts. Wasn't a week ago that Bernanke sounded optimistic about the economy spurring markets? It was also three weeks ago that Bernanke during his semi annual report to Congress that the Fed is "not prepared to take any specific steps in the near term particularly since we're still also evaluating the recovery and the strength of the recovery."

What ever the policy actions we get today will be just noise. The market has already rallied. The economy is weak and the Fed is limited in what they can do, all of this leads me to believe we get a significant sell off if the Fed does nothing and a smaller sell off if they in fact start a Treasury buying program.

No comments:

Post a Comment