Stocks were up with big gains before selling pressure cut them back down in the afternoon. Then a late bounce made for a better finish.
Early trading was stirred by news that Germany gave its support to the expansion of the European Financial Stability Funds – ie: Greece et al.
For the first time in several weeks economic data also was encouraging. The latest weekly initial jobless claims count dropped by 37,000 from the prior week to 391,000, which is the first time in more than a month that initial claims have fallen below 400,000.
And the second quarter final GDP number showed a growth of 1.3%, which marks an increase from the 1.0% growth rate first accessed.
My last article was on the FOMC and Operation Twist and it has been read more than any other, so after running across a very informative paper by Dr. Gary North that chronicles the important events since the fall of 2008 I had to share portions. It is rather long but contains an excellent review of the 2008 crash that began the mess we are in, and a blow by blow commentary and explanation of events since. He finishes with some sober thoughts of where we may go as more events unfold in Europe and in the U.S. Because of its length it is divided up into 3 articles but all will be on this site by Friday evening for weekend reading. It is well worth the time in reading this if you are all looking to make some sense out of why we are here and where we may be going. It will likely help you decide what to do.
The European and Greek debt crisis has been running rough shod over US markets of late. It’s like one day we her that a default seems unavoidable and the market topples. (That’s a big deal because it would almost certainly trigger a European recession. And since Europebuys about 20% of U.S.exports, the recession would quickly leap to our side of the pond. Then the next day, some European leaders get together and propose a bailout and markets rush back up.
The market saw a problem with Chairman Bernanke’s new Operation Twist. The name refers to the Fed’s decision to sell short term bonds and buy long term bonds to twist the interest rates around. The goal is to lower long term rates so that mortgage costs will go down and house sales will go up; then all will be right with the world. Lower rates are also intended to make business loans more attractive.
The problem is with the Fed’s strategy interest rates are already on the floor. People aren’t buying houses because mortgages are too expensive. People aren’t buying houses because they don’t have the necessary 20% down payment, or sterling credit. Some don’t have a job so not even a free zero percent mortgage rate would not help them.
Businesses are not borrowing money to expand because there is no need to expand. Consumer spending is so low, many businesses are happy just to keep their doors open.
Chairman Bernanke has also decided to make king sized loans to European banks that are in trouble. The move isn’t as generous as it may first appear. The money is to be used by the banks to service loans to U.S.creditors who must be paid in dollars. In other words, the money will come back. At least that’s the plan. This program also has little potential to reinvigorate the U.S.economy either though.
Dr. North begins: In its written release after the August 9 Federal Open Market Committee policy meeting, the Fed included a statement that was unusual because it was so specific. “The Committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid 2013.”
In the recent past, the Fed has stated its plans to keep rates low for an “extended period,” but it has never chosen dates as if future policy had a schedule. The statement was also significant because it means the federal funds rate will continue close to zero. Not surprisingly, longer term Treasury rates dropped on the announcement. The 2-year note yield fell to 0.185%, an all-time low, and the 10-year note yield hit 2.033%, below the previous 2.034% low reached on Dec. 18, 2008, after the collapse of Lehman Brothers drove investors to the safe haven of Treasuries.
The Fed is not alone in keeping central bank short-term rates close to zero in response to sluggish and declining global economic growth and the inability of massive monetary and fiscal stimulus to revive economic activity. Central banks over the world are combating similar situations.
Zero interest rates are significant. Zero is a floor below which interest rates normally don’t fall, although the 3-month Treasury bill rate recently was negative amidst investors’ mad rush for liquidity and the safe haven of government paper. (Imagine paying someone else for the privilege of holding your money). Most observers have no experience to understand or forecast in this environment. More significantly, central bankers and fiscal policy managers haven’t seen this environment either, which makes forecasting the outcome of their actions and any unintended consequences very difficult.
You’ll probably recall how the Fed got to its current federal funds target of 0-0.25%. In early 2007, the subprime residential mortgage market started to fall apart. By August, the Fed had cut its discount rate and the federal funds target rate shortly thereafter, initiating the declines that resulted in the current levels.
In 2008-2010, in what became known as QE1, the Fed bought $300 billion in U.S. Treasuries, $1.25 billion in residential mortgage- related securities and $100 billion in Fannie Mae and Freddie Mac securities in an attempt to further prop up the faltering housing market and reduce mortgage rates. But these efforts were of little aid to the housing market, and prices resumed their decline in mid-2010 after the effects of the tax credits for new home buyers expired. Prospective buyers were not getting mortgages because they could not afford the interest rates – they were at multi year lows – they were not getting mortgages because they did not have a 20% down payment.
So, in August 2010, Fed Chairman Bernanke hinted at QE2, which was implemented in late 2010, ran through mid-2011 and initiated the purchase of a net additional $600 billion in Treasuries.
Like QE1, QE2 did put money in the hands of investors in return for Treasuries, but had no follow up effects. The Fed creates more reserves by buying Treasuries and other securities. It doesn’t generally print money as the media reports. It requires the cooperation of the banks as lenders and the creditworthy borrowers to turn those reserves into loans and money. But banks have been reluctant to do so, borrowers too, and excess reserves over and above reserve requirements now total about $1.6 trillion. Nonfinancial businesses have more than ample cash and little desire to borrow. Creditworthy individuals are also reluctant to borrow, and instead are paying down their mortgage and other debts. This is a logical reaction to the environment, and companies and people are deleveraging.
Even so with QE2, the Fed did not achieve its goal of reducing mortgage rates further to aid distressed homeowners. When Fed Chairman Bernanke hinted at QE2 last August, 30 year fixed rate mortgage rates did fall along with 10 year Treasury note yields to which they are linked, but then rose when the program was finally announced in November.
The central bank did, however, succeed in staving off the threat, or at least the fear, of deflation as QE2 fueled the already expanding commodity sectors. And it succeeded in stimulating stock prices. All the extra money and reserves had to go somewhere. Investors reacted as they had in the past to Fed easing by buying equities.
The rally in stocks and commodities reversed last spring, however. The 2010 sovereign debt crisis in Europewas coming to the forefront again with more intensity. U.S.consumer confidence nosedived in response to Washington’s handling of the federal debt limit and fiscal restraint as well as persistent high unemployment. And the prospects of slower global growth and possible recession now threaten the growth in corporate profits.
The Fed’s goal with QE2 was not to aid just the folks on top that could afford to hold stocks while punishing the lower tier with the higher energy and food costs that flowed from commodities rising. But that’s what happened. Until very recently, Americans on the top have benefited from the two-year rally in stocks, commodities, foreign currencies and other investments that were slaughtered during the Great Recession. The rest of Americans were more affected by lingering high unemployment and by falling house prices.
Despite their lack of overall effectiveness, QE1 and QE2 actions were undertaken because conventional monetary policy, cutting the federal funds rate, was not doing the job. The Fed was pushing on the proverbial string.
Trade with a plan.