Daily Note – The Great Transition



One small step for Bernanke one giant leap for Financial Markets.

The tale of  three transitions

Is gold only weak for now? 

United States: Better housing data but was anyone even paying attention?

Eurozone: EU finance ministers agree on bank-failure plan


Good Morning all,

I was watching Keane/Viera on TV last night.

Great television and a fantastic idea to put two of the most important footballers of a generation together. However what interests me more than the old clips of battles on the park, is how these guys make the transiton between the intensity of their football careers, to whatever they are going to do in the rest of their “normal” lives.

Many footballers don’t make that transition. Some end up in the gutter, others become bitter and still hanker over the glory days.

Making the transition from the intensity of QE to something more normal was also the objective of the FOMC yesterday. More accurately, making three transitions is now the “new normal”.

The tale of  three transitions

The first transition is the personal transition from Bernanke to Yellen. The second is the policy  transition from full throttle QE to something else which would maintain massive monetary support for markets and they hope, by extension, the economy. The third transition is from a focus on falling unemployment as the policy trigger, to a focus on rising inflation as the policy trigger.

The Fed started the tapering process with a $10 billion reduction in the size of the January QE purchases. The move is distributed equally between Treasuries and MBS.

The FOMC also attempted to strengthen the forward guidance (expectations of when the first rate hike will be). It did this by putting less significance on the defined 6.5% unemployment threshold and more on inflation returning to 2%.

The strength of the forward guidance is not as compelling as I thought it might be. I thought a reduction in the target unemployment rate was a more powerful way of achieving the same effect. The Fed may well be waiting to do this at some point next year, depending on how the economy develops.

The key message from the FOMC on tapering is the same as it has been since Chairman Bernanke began to publicly discuss tapering in May: the decision to taper is economic data dependent and not predetermined. And the economic data is also dependent on the level of stock, bonds and housing markets because the wealth effect associated with strong markets is the very “trickle down” mechanism which should “ramp up” consumer spending.

The Chairman stressed that the incoming Chairman Janet Yellen was on board  but frankly he was hardly going to say she was vehemently opposed.

Assuming the current pace of economic growth, there will be regular further “tapering” next year unless the markets fall out of bed. This brings us back to the hostage dilemma we spoke of yesterday; the kidnapper is still wearing Prada.

The Federal Reserve like the Bank of England in the UK is trying to make the transition from direct policy action (QE) to verbal intervention (forward guidance).

The problem with this policy, as Governor Carney in the UK has found, is that in the face of strengthening economic data, the markets can test your resolve.

Looking more closely at forward guidance, the key message is that the Fed Funds rate will not be raised until some distant point in the future. Indeed that point may be so far in the future that it’s not on the horizon yet.

An other key point is that the Federal Reserve is trying to refocus the aim of forward guidance on the inflation target of 2% and away from the unemployment rate threshold of 6.5% (as an aside I expect this threshold to be hit before the summer of 2014).

Given this transition, future rate hike decisions will depend much more on inflation getting back up to 2% and beyond. As I talked about in our launch note yesterday, inflation globally seems very well anchored at the moment and Bernanke is essentially saying they are happy to wait to see any inflation before acting.

The market would be concerned that the problem with that strategy is once the inflation genie is out of the bottle, it’s hard to put back in again. Just ask Mervyn King the previous chief bottlewasher at Threadneedle Street before Steve Silvermint arrived.

The US bond curve is steepening (higher rates at the long end) because the implication here is that the Fed runs this risk of staying too low for too long, trying to keep the kidnappers happy  and thereby, stoking inflation. Given that the US 10 year yield had rallied 20bps in the last two weeks, the moves last night, while volatile, were reasonably modest.

I remain bearish on longer duration bonds, particularly the US 5 Year note. Likewise gold has been hammered (hit the key 1200 level this morning), as higher rates devalue any asset that returns zero. This gold aversion might turn out to be rather shortsighted (see below).

The USD for me is the most interesting play this morning particularly against the Euro, while bond markets had priced yesterday’s move in to some extent, Euro/USD at 1.38 was miss priced and not anticipating it. The USD has strengthened back to 1.3670 this morning and we expect this trend to continue back to the low 1.30’s in the New Year.

Finally, stock markets did what everyone including myself thought they wouldn’t do on this type of news and rally hard (both the S&P and the Dow finished at all time highs). Europe is up again this morning, while we have no investment in stock markets at the moment we are cautious, given stretched valuations. How much of last night’s move was a “Santa rally” and what does the start of 2014 look like?

It will interesting to see if we can finish the week at these elevated levels. I would be skeptical but much more on stocks in the coming weeks.

Gold: A Matter of Trust

The chart below is the S&P 500 vs Gold this year. You can see quite clearly the S&P rally is more about positive growth concerns than liquidity. Gold remains under pressure with a new yearly low not out of the possibility.


For me the gold question is one of trust. Do you trust these central bankers to get it right. If so, gold deserves to be where it is. If on the other hand you believe that the record of central bankers is patchy at best and their PhD confidence is overblown, then gold is your protection.

On the central bankers’ side, the economy is recovering, no doubt. On the doubters’ (the gold bugs) side is the fact that the record of the central bankers and bubbles has been very patchy.

Under Greenspan we got the bailout of Long-Term Capital Management after the Russian crash in 1998, the dot-com crash and the asset bubble in housing as a way out of the 2001 recession, itself a function of the busting of the previous dot-com carryon.

Under Bernanke there was the subprime mortgage market crash/banking crash, which was like the dot-com bust before it “fixed” by the present “bailout bubble” of trillions of free dollars inflating asset values and driving them away from fair value.

Maybe the gold bugs, out of favour right now, have a point.

United States: Better housing data but was anyone even paying attention?

Away from the Federal Reserve the data remained solid in the US, with better than expect Housing Starts and Building Permits. As I talked about earlier in the week, housing, having flattened off at the end of the summer, seems to be returning to an uptrend.

19 DEC T1.1

Eurozone: EU finance ministers agree on bank-failure plan

In the final step on the road to the ECB taking over the monitoring of Eurozone banks, agreement has been reached to establish an agency to fund and shut down problem banks. We have got very little detail on the fund itself but it seems to be €50b and will be part funded by banks themselves. This is of particular interest in Ireland because, my hunch is the stress test next year will expose all not just some of the balance sheets of Irish banks. Spanish banks are probably worse!

More on this tomorrow.

19 DEC T2

Finally this morning we note with keen interest a continuing fall in wage growth in Italy. This is to be closely watched given the deflationary concerns.

Lastly, on the issue of great transitions such as the one the Fed is trying to engineer now, as we have seen from Roy Keane’s various incarnations since leaving Man Utd, even the most talented find moving from one state to another remarkably taxing.


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Categories: Daily Note