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Fed in a Box

 

Here’s a note from our Macro team on why any form of incremental easing – if it comes at all – will be a 2012 event.

 

Conclusion: As we anticipated, Chairman Bernanke did not provide an indication that incremental easing is coming in the short term today in his speech in Jackson Hole. Our view is that if it comes, it is likely a 2012 event.

 

The most focused-on stock market event of the week in Jackson Hole, Wyoming has turned out to be largely a non-event. The text of Chairman Bernanke’s speech was circulated prior to him giving the speech at 10am eastern this morning. We spent time parsing through his comments and there was really no change from his prior public comments. Specifically, Bernanke stated the following this morning about policy duration:

 

“In particular, in the statement following our meeting earlier this month, we indicated 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. That is, in what the Committee judges to be the most likely scenarios for resource utilization and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years.”

 

Chairman Bernanke went on to say that while the Federal Reserve is willing to “employ its tools as appropriate to promote a stronger economic recovery in a context of price stability”, he stopped short of indicating what form incremental stimulus would take and on what time frame. Thus, the great QE3 waiting game continues.

 

Our view of incremental easing remains that the Federal Reserve will be in a proverbial box in terms of incremental easing until at least the end of 2011, if not well into 2012. The primary reason for this is simply that the data will not support further easing.

 

In the chart below, we graph all-items CPI going back three years and highlight when QE1 was announced and then implemented and also highlight when QE2 was hinted and then implemented. The key takeaway is that inflation was running at much lower levels, largely below 1%, when the first two rounds of quantitative easing were implemented. Currently, this measure of inflation is north of 3% and set to remain at that level through the next couple of quarters based our models.

 

 Fed in a Box - macro chart 1 8 27 11

 

Just as pertinent to Fed decision making is employment data. As the chart below outlines, in the prior two periods of quantitative easing, monthly non-farm payrolls witnessed a substantial and sustained decline of at least three months. As of now, monthly non-farm payrolls are still positive, albeit marginally and the last three months, ending in July, have averaged additions of only 72K. This is a substantial decline from the prior three months, which averaged 215K additions. Nonetheless, history suggests that we would need to see negative payrolls for a sustained period prior to incremental easing being implemented.

 

 Fed in a Box - macro chart2 8 27 11

 

Stepping back, the majority of Bernanke’s speech today related to the theme of the actual conference, which is the outlook for the longer term prospects for the U.S. economy. Bernanke spent a good portion of the speech addressing his perspective on both the positives and negatives relating to long term economic growth of the United States. The one area which he flagged as an impediment to the economic prospects was fiscal policy. To quote the Chairman:

 

“. . . the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.”

 

In part, the negotiations around the debt ceiling have been an issue, but, if anything, they characterize a short term impediment. Longer term is the actual issue of structural deficits and debt. While we aren’t necessarily surprised, it would have been valuable to have Bernanke address these issues head on for what they are: long term impediments to U.S. growth. We have oft quoted Reinhart and Rogoff’s data from, “This Time is Different”, which clearly shows that as nation’s debt-to-GDP accelerates beyond 90%, its future growth slows. In the last chart below, we show this graphically for the Japanese economy.

 

 Fed in a Box - macro chart 3 8 27 11

 

My colleague Darius Dale wrote a note earlier today discussing monetary policy of Australia. In the note, he quoted Bank of Australia Governor Glenn Stevens who recently noted:

 

“In terms of macroeconomic ammunition, there would be not that many countries who could say they had more than us in the event of a really big episode.”

 

We are obviously not big fans of government intervention, but one key risk to consider in a more dire economic scenario, is that the Federal Reserve, unlike Australian counterpart, is largely out of ammo.

 

Daryl G. Jones

Director of Research

 


The Week Ahead

The Economic Data calendar for the week of the 29th of August through the 2nd of September is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

 

The Week Ahead - llac1

The Week Ahead - llac2

 


Weekly Asia Risk Monitor

As usual, we’re keeping it brief. Email us at if you’d like to dialogue further on anything you see below.

 

THEME

Sticky Stagflation. Period.

 

PRICES

As consensus continues to investigate the health of the global economy, we’re starting to see some alpha being generated across Asian equity markets. Indices were mostly up, but the 610bps delta between the region’s best performer (China’s Shanghai Composite Index) and the region’s worst performer (Thailand’s Stock Exchange of Thai Index) highlighted the heterogeneity of wk/wk performance this week.

 

In Asian currency markets, the Aussie dollar (+1.7% wk/wk vs. USD) and the New Zealand dollar (+2.6% wk/wk vs. USD) were supported by bullish hope across the commodity complex ahead of what many expected to be the Fed’s next attempt to inflate global asset prices.

 

In Asian fixed income markets, the +23bps wk/wk increase in Australian 2yr sovereign debt yields also took a cue from Fed speculation (the hawkish RBA board is likely to tighten further if the Fed chooses to perpetuate global inflation once more). The move was supported by a +16bps wk/wk move in Aussie 1yr interest rate swaps. Another interesting callout on the inflation side was the +13bps back up in 10yr Honk Kong sovereign bond yields on inflation risk. Despite the territory teetering on the brink of recession, CPI backed up to a near 16-year high of +7.9% in July!

 

Weekly Asia Risk Monitor - 1

 

Weekly Asia Risk Monitor - 2

 

Weekly Asia Risk Monitor - 3

 

Weekly Asia Risk Monitor - 4

 

Weekly Asia Risk Monitor - 5

 

Weekly Asia Risk Monitor - 6

 

Weekly Asia Risk Monitor - 7

 

Weekly Asia Risk Monitor - 8

 

Weekly Asia Risk Monitor - 9

 

KEY CALLOUTS

China: The key developments out of China this week centered on the direction of monetary and fiscal policy. The China Securities Journal reported that it was likely that Beijing increases fiscal spending and eases monetary policy in “certain sectors” in the event the global growth slows incrementally from here. On the tightening side, it was reported today by Bank of America that China’s central bank broadened bank reserve requirements regulation to include margin deposits. The new measure, which begins on Sept. 1st and is fully implemented on Feb. 15th, is roughly the equivalent of a +130bps increase in reserve requirements (per BAC analyst Lu Ting).

 

A +130bps increase in RRRs would be rather significant given the scope of China’s previous tightening (+600bps in RRRs since Jan. ’10; +125bps in interest rates since Oct. ’10), so we’ll look for clues in market prices to determine whether or not the Chinese economy is facing yet another headwind from a liquidity perspective. For now, China’s money market rates aren’t confirming Ting’s aggressive assumptions (O/N Shibor down -11bps d/d; 7-day repo rate down -41bps d/d). We’ll continue to closely monitor for changes on the margin in China’s official policy rhetoric, as speculation around China’s next big policy initiative is likely to take a front seat to growth and inflation dynamics in the event global growth continues to slow.

 

Hong Kong: Inflation and bad macroeconomic policy continue to have us bearish on Hong Kong. July CPI accelerated to +7.9% YoY (vs. +5.6% YoY in June), though largely on a one-off property market distortion. Even still, the distortion was created by a policy decision a year prior (waiver of public housing rentals), reminding us that we cannot get something for nothing when it comes to the economy. Whether or not they’ll be in office to see the outcome, there is a price to pay for every decision policymakers make.

 

In Hong Kong’s case, their continued insistence on pegging the Hong Kong dollar to the USD means they are unable to hike interest rates to fend off a pending inflationary spiral driven largely by a property price bubble (higher rents) and tightness in the labor market. The recent elevated minimum wage introduction and the +7% increase in civil servant pay will only perpetuate the fodder by which inflation is being fanned throughout the Hong Kong economy. As we called out a few months back, Hang Seng investors are appropriately paying a lower multiple for Hong Kong’s Sticky Stagflation.

 

Japan: For the sixth time in five years, Japan’s head of state is quitting on the job. Prime Minister Naoto Kan announced his resignation today, and will officially step down early next week. Beyond the sloppy political posturing to become his replacement, there isn’t much more to report. Aside from electing a leader who isn’t afraid to challenge and overcome the country’s stubborn Keynesian resolve, Japan is likely to continue to see economic stagnation over the long-term TAIL (nominal GDP grew ZERO percent from 1991).

 

A lack of effective political leadership is one of the key reasons Moody’s downgraded Japanese sovereign debt one notch to Aa3 with a stable outlook. We downgraded Japanese equities in 4Q10 via our Japan’s Jugular presentation and we continue to point to exponential growth in Japan’s sovereign debt burden (over 220% of GDP) as being a major constraint on consumer and corporate confidence, as well as a major constraint on crafting and implementing sound regulation and monetary policy – all of which ultimately contributes to structurally depressed rates of economic growth.

 

India: Inflation and interest rates continue to dominate the headlines coming out of India. Inflation largely accelerated on a YoY basis in the week ending 8/13: food inflation came in faster at +9.8%; energy inflation was flat at +13.1% YoY; and primary articles inflation accelerated to +12.4% YoY. As we continue to point out, Sticky Stagflation keeps the Reserve Bank of India in a hawkish stance at least through 3Q (our models have WPI peaking in August on a YoY basis).  RBI Governor Duvuuri Subbarao affirmed our belief with his recent commentary:

 

“With weak supply response, inflation remains an important macroeconomic challenge. As a result, both fiscal and monetary space is limited for any counter-cyclical stimulus if global conditions deteriorate.”

 

India’s interest rate swaps market took his word for it, with the one-year tenor backing up a marginal +2bps wk/wk (still down -53bps MoM, however). They are, however, trading below the RBI’s benchmark policy rate of 8%, suggesting that the market is pricing in the RBI’s next move over the NTM to be a rate cut, rather than the 12thrate hike of this current tightening cycle. The current setup of market expectations is largely due to a slowdown in India’s economic growth rate, and, combined with slowing credit growth (+18.5% YoY in July), is supportive of Indian lenders purchasing record amounts of bonds in July ($18.9 billion). For reference, India’s 2yr sovereign debt yields have fallen -6bps wk/wk and -11bps over the last three months. This compares to a +133bps rise over the last year.

 

Australia: The key news out of Australia this week largely centered on monetary policy and the Reserve Bank of Australia’s likely next move. As we point out earlier, Australia’s bond market and interest rate swaps market are aggressively betting for rate cuts. Australia’s currency, the Aussie dollar, largely continues to anticipate tighter policy ahead (up +1.7% wk/wk and +19.4% YoY vs. USD). As we have pointed out in our recent research on Australia, Sticky Stagflation is keeping RBA Governor Glenn Stevens and his crew in a box.  On the brighter side of things, in the event global economic conditions take a turn for the worse, Stevens has adequately prepared his country to weather the storm – just as he did in ‘08/’09, saying at a hearing today:

 

If we did see a very dramatic change for the worse in the global economy, certainly we have plenty of interest rates to play with if need be.”

 

Singapore: The trade-heavy, open economy of Singapore (exports = ~216% of GDP) continues to be a bellwether in our model as a gauge of the state of the global economy. Unfortunately, that gauge remains bearish. Sticky Stagflation dominated Singapore’s economic data this week: industrial production growth slowed in July to +7.4% YoY (vs. a prior reading of +10.7% YoY) and CPI accelerated in July to +5.4% YoY (vs. a prior reading of +5.2% YoY).

 

Looking at Singapore’s domestic economy, the country will hold a presidential election tomorrow – its first in 18 years. This is more ceremonial than anything, as the president of Singapore is largely a symbolic role. In fact, Singaporean Law Minister had this to say in response to recent campaign promises of “checks and balances” out of candidates Tan Jee Say, Tan Kin Lian, and Cheng Bock (none of whom are officially endorsed by the ruling People’s Action Party):

 

“A president would be acting unconstitutionally by engaging publicly on political issues or contradicting the government. Direct elections do not give the elected president the right to speak independently. The president must follow the Cabinet’s advice and cannot act or speak on issues of the day except as advised by the Cabinet.”

 

Regardless of the outcome of tomorrow’s election, the incoming president will have little ability to actually govern. While the president can veto budgets and key public appointments, such action is easily overturned by a majority vote in parliament – where the PAP holds 81 of 87 seats. As such, the election will be perceived as little more than a broad-based gauge of sentiment towards the ruling PAP regime.

 

Thailand: Sticky Stagflation rears its ugly head yet again, this time in Thailand’s real GDP growth, which slowed in 2Q to +2.6% YoY (vs. +3.2% YoY in 1Q). The stagnating economic growth was met with a +25bps rate hike designed to front-run simmering inflationary pressures being brewed via the new regime’s lax fiscal policy, its decision to aggressively hike minimum wages, and its rice price-fixing scheme. Opposition leader, Abhisit Vejjajiva, who was recently stripped of his title of Prime Minister as a result of the recent election, had this to say regarding the new government’s aggressive initiatives:

 

“If we destroy the disciple and independence in fiscal and monetary policies, inflation will accelerate.”

 

A worthwhile lesson indeed.

 

Darius Dale

Analyst


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The Fed Remains in the Box

Conclusion: As we anticipated, Chairman Bernanke did not provide an indication that incremental easing is coming in the short term today in his speech in Jackson Hole. Our view is that if it comes, it is likely a 2012 event.

 

The most focused-on stock market event of the week in Jackson Hole, Wyoming has turned out to be largely a non-event. The text of Chairman Bernanke’s speech was circulated prior to him giving the speech at 10am eastern this morning. We spent time parsing through his comments and there was really no change from his prior public comments. Specifically, Bernanke stated the following this morning about policy duration:

 

“In particular, in the statement following our meeting earlier this month, we indicated 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. That is, in what the Committee judges to be the most likely scenarios for resource utilization and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years.”

 

Chairman Bernanke went on to say that while the Federal Reserve is willing to “employ its tools as appropriate to promote a stronger economic recovery in a context of price stability”, he stopped short of indicating what form incremental stimulus would take and on what time frame. Thus, the great QE3 waiting game continues.

 

Our view of incremental easing remains that the Federal Reserve will be in a proverbial box in terms of incremental easing until at least the end of 2011, if not well into 2012. The primary reason for this is simply that the data will not support further easing.

 

In the chart below, we graph all-items CPI going back three years and highlight when QE1 was announced and then implemented and also highlight when QE2 was hinted and then implemented. The key takeaway is that inflation was running at much lower levels, largely below 1%, when the first two rounds of quantitative easing were implemented. Currently, this measure of inflation is north of 3% and set to remain at that level through the next couple of quarters based our models.

 

The Fed Remains in the Box - 1

 

Just as pertinent to Fed decision making is employment data. As the chart below outlines, in the prior two periods of quantitative easing, monthly non-farm payrolls witnessed a substantial and sustained decline of at least three months. As of now, monthly non-farm payrolls are still positive, albeit marginally and the last three months, ending in July, have averaged additions of only 72K. This is a substantial decline from the prior three months, which averaged 215K additions. Nonetheless, history suggests that we would need to see negative payrolls for a sustained period prior to incremental easing being implemented.

 

The Fed Remains in the Box - 2

 

Stepping back, the majority of Bernanke’s speech today related to the theme of the actual conference, which is the outlook for the longer term prospects for the U.S. economy. Bernanke spent a good portion of the speech addressing his perspective on both the positives and negatives relating to long term economic growth of the United States. The one area which he flagged as an impediment to the economic prospects was fiscal policy. To quote the Chairman:

 

“. . . the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.”

 

In part, the negotiations around the debt ceiling have been an issue, but, if anything, they characterize a short term impediment. Longer term is the actual issue of structural deficits and debt. While we aren’t necessarily surprised, it would have been valuable to have Bernanke address these issues head on for what they are: long term impediments to U.S. growth. We have oft quoted Reinhart and Rogoff’s data from, “This Time is Different”, which clearly shows that as nation’s debt-to-GDP accelerates beyond 90%, its future growth slows. In the last chart below, we show this graphically for the Japanese economy.

 

The Fed Remains in the Box - 3

 

My colleague Darius Dale wrote a note earlier today discussing monetary policy of Australia. In the note, he quoted Bank of Australia Governor Glenn Stevens who recently noted:

 

“In terms of macroeconomic ammunition, there would be not that many countries who could say they had more than us in the event of a really big episode.”

 

We are obviously not big fans of government intervention, but one key risk to consider in a more dire economic scenario, is that the Federal Reserve, unlike Australian counterpart, is largely out of ammo.

 

Daryl G. Jones

Director of Research


Uncertainty: SP500 Levels, Refreshed

POSITION: Short Financials (XLF)

 

I accept Uncertainty in my risk management process. Period.

 

The only thing that I am certain about is where my risk management lines are and that they will change as price, volume, and volatility data does.

 

I’ve been saying there was a heightening probability of a market drawdown on Fed “expectations” day. That’s all risk management is – understanding which way the uncertainty is tilting and considering heightened or lowered probabilities.

 

While it looked like the SP500 had an immediate-term shot at making a lower low of 1108 today (when it was down 2% in a straight line post Bernanke not doing QE3), it obviously looks less likely now. That could change in 3 hours. So I’ll just wait and watch.

 

The long-term TAIL of resistance remains at 1256. Immediate-term TRADE resistance is now 1183. And immediate-term TRADE support moves up 2 points to 1110.

 

In the Hedgeye Portfolio, I covered our Italy short (EWI) this morning as Europe rallied “off the lows” into the close. That makes the LONG/SHORT positioning pretty much neutral with 10 LONGS and 10 SHORTS, for now…

KM

 

Keith R. McCullough
Chief Executive Officer

 

Uncertainty: SP500 Levels, Refreshed - SPX


JCP: Shorting Again

 

Keith just re-shorted JCP in the Hedgeye virtual portfolio - again here on an up day managing near-term risk around a very high conviction TREND and TAIL short idea with Trade Support at $23.03. There is no change to our thesis on the name, only price.

 

Please contact  if you would like see our fundamental view on why there is a meaningful duration mismatch between the storytelling on the Street vs. economic reality.

 

JCP: Shorting Again - JCP Trade Trend 8 26 11

 

 


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