Guest Post: Third Quarter Economic Update by Dorothy Jaworski

The Fed Strikes Again

I spent a lot of time during September reviewing and articulating many reasons why the Federal Reserve should restrain itself and not continue with additional easing. First of all, if they continue to buy securities, they are removing many of the high quality securities from the marketplace, possibly causing a disruption or shortage in the markets. They risk the potential of severe inflation and rapidly rising interest rates if the banks begin to put the currently idle reserves to work in the form of loans and the Fed does not tighten accordingly.

They risk the loss of credibility as they try to unwind their portfolio by dumping securities onto the markets, raising interest rates, and breaking their promises to keep rates low. Then, after ignoring all of my advice, the Fed went ahead at their meeting of September 13th and acted anyway, extending their “promise” another six months to keep the Fed Funds rate at low levels until mid 2015. Really? The Fed can barely project the next twelve months, let alone the next thirty months into the future.

They did succeed in lowering the entire term structure of interest rates once again, even while we remain incredulous. We may be skeptical, but the markets keep telling us: Don’t fight the Fed!

The Fed also embarked on their third quantitative easing program, now dubbed “QE3,” in which they will buy $40 billion of mortgage backed securities per month until unemployment comes down. This open ended buying campaign has been facetiously called “QE infinity” by some pundits and will add to their already gigantic investment portfolio, which already includes the $2.3 trillion of securities amassed during QE1 and QE2.

And don’t forget that they are still finishing the $667 billion Operation Twist Program by year end 2012, where they sell shorter maturities and buy longer term ones to push interest rates lower. Or should I say “manipulate” interest rates lower? Gone is our best indicator—the yield curve—which the Fed has turned into a useless string of percentages. Granted, the Federal Reserve is not the only presence pushing long term rates lower; weaker economic data and the flight to quality into Treasuries for safety during the European debt crisis lowered rates as well.

If I said it once, I said it one thousand times: “My biggest fear is that the Fed is sowing the seeds of the next crisis with their flatter yield curve tricks, leaving many investors holding these low yielding long bonds when rates rise in future years, unable to get out without substantial capital losses.” I know I risk sounding like Charles Plosser, but so be it.

It seems to me that reducing burdensome regulations and not implementing harsher capital requirements would be more effective alternatives to incentivize lending than pushing all yields toward zero while buying up all of our bonds.

Happiness

Written into the law in 1977 is the dual mandate of the Federal Reserve: price stability and maximum employment. Where this surprising third goal came from, I have no idea, but Ben Bernanke added it in August during a recorded speech for a Cambridge, Massachusetts conference. He said that to measure economic progress, we need to gauge “happiness,” because, after all, the ultimate objective of Fed policy decisions is promoting “the enhancement of well being.”

Really? Maybe Ben is thinking of the Constitution and the pursuit of happiness. He said we should use a measure of happiness like that used by the tiny Himalayan nation of Bhutan, which utilizes a Gross National Happiness index rather than a Gross National Product index for its 700,000 people.

Bhutan, a Buddhist nation between India and China, began calculating the Gross National Happiness, or “GNH,” Index in 1972. “The GNH Index is meant to orient the people and the nation towards happiness, primarily by improving the conditions of not-yet-happy people.” The Index incorporates satisfaction, living standards, education, physical and mental health, safety, community, family and social ties, and leisure.

In all, there are 33 factors that go into the Index creation. The latest available numbers that I saw were from 2010 and they showed 10% of the people were unhappy and almost 41% were indeed happy. The rest of the people are somewhere in between. In March, 2012, the Bhutan GNH Index was on a UN meeting agenda, no doubt to promote the idea of promoting well being over weak economies. We should all be so lucky.

Ben Bernanke pretends that he is happy, but he must be getting quite angry. He started easing in 2007 and has thrown every easing tool in his playbook at us and unemployment remains stubbornly high. The unemployment rate has fallen to just over 8%, not because of great job growth but because of people dropping out of the labor force in droves.

GDP growth crawls along at a mere 1.3% in the second quarter of 2012. Inflation is running at about 2% per year. He just dumped QE3 and another “promise” on us. He may get angrier still if things don’t improve soon. If he could create jobs rather than money, we would all be a lot happier.

Gas Prices, the Economy, and Housing Bright Spots

For the third year in a row, we saw economic growth slow throughout the summer. Job growth has noticeably slowed in recent months and the unemployment rate remains above 8% in August. Oil prices spiked to near $100 per barrel and gas prices sit close to $4 per gallon right now, as they have in two of the past three years.

Hurricanes during August, tensions with Iran, and Arab unrest across northern Africa are among the commonly cited reasons for the continued high prices. Consumers usually cut back their expenditures on other items when we reach these price levels and that is what we expect would be happening again this time, leading to some of the recent weakness in manufacturing data.

Housing price data is turning into the surprise of 2012. All of the national indices that I track, including the Case Shiller, FHFA, and CoreLogic home price indices have turned positive on a year-over-year basis. The strongest indices have been FHFA, +3.7% in July and CoreLogic, +4.6% in August. The Case Shiller rose year-over-year by .6% and 1.2% in July, for the 10 city and 20 city indices respectively. Distressed sales are becoming a lesser portion of total sales. Is the long awaited turning point in housing upon us?

Maybe it is nationally, but Bucks County (PA) has yet to participate. For the most recent available data from the Prudential Fox survey, Bucks County home prices, as of the end of June, were still down year-over-year by 2.2%.

The rise in home prices may serve to lift consumer confidence and with it, demand for home buying. The Federal Reserve is determined to lower mortgage interest rates through its new QE3 buying program, spurring more demand. The inventory of unsold existing homes is 6.1 months worth of sales, which is a normal supply.

The rise in home prices will also gradually improve some of the underwater mortgages, which were 10.8 million with negative equity in the second quarter of 2012, according to CoreLogic. Maybe appraisers will not be afraid to increase a price estimate for a change.

So, once again, I remind you that the economy is slowly moving ahead. With such a large amount of easing by the Federal Reserve, we should expect this scenario to continue. Much uncertainty still exists as to whether Congress will extend the tax cuts that are set to expire on January 1, 2013. Most consumers and businesses will likely take a wait-and-see attitude toward the Presidential election as well. So stay tuned!

Thanks for reading. DJ 10/03/12

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Guest Post: Second Quarter Economic Update by Dorothy Jaworski

Second Quarter Surprises

We received two big surprises at the end of the second quarter — one from Washington and one from an ocean away. On June 28th, the Supreme Court upheld the Affordable Care Act as constitutional, calling penalties on individuals for failing to purchase health insurance a “tax.” This decision sets in motion a series of steps to implement the law over the next few years along with the estimated $813 billion in taxes and levies over the next ten years.

On June 29th, we received word that the seventeen Eurozone members had agreed on a program to save governments and banks from financial stress. Raise your hand if you think the Euro crisis is over. Okay, then, raise your hand if you think the Euro crisis is only averted or postponed for now. Yeah, I agree. We’ve seen this show before; we are bound to see it in reruns in the next year or two.

The markets did not care for the Supreme Court decision, with stocks ending slightly down for the day on the prospect of increased taxes. But the markets loved the Eurozone agreement, especially Angela Merkel’s capitulation, and stocks rose about 2.5% to 3% on the last day of the quarter. Can you say “short covering” rally?

Although the major indices fell by 2.5% to 5.1% during the second quarter, they are still up 5.4% to 12.66% for year-to-date 2012. This is good news and right in line with the historical tendency of stock markets to rise 11% on average during election years since 1928.

Tempest in a Teapot

J.P. Morgan CEO, Jamie Dimon, uttered the words “tempest in a teapot” to describe the issues raised in articles by the Wall Street Journal in April regarding the risks of huge complex credit derivatives trades by J.P. Morgan’s London office. One trader in particular was cited as the source of the high risk trades and is nicknamed the “London Whale” for his normally large market positions. By the time May rolled around, we received a surprise that saw Jamie Dimon announcing losses of $2 billion that were “misguided” and “egregious” mistakes. The losses could reach $5 to $6 billion before they are unwound, according to sources. (The NY Times even speculated that the losses could top $9 billion.) We will not know until J. P. Morgan announces them as part of their second quarter earnings release in July.

Dimon and his bank have long been viewed as one of the best run banks in the world and leaders in risk management. They are even credited with developing one of the premier risk measurement systems called Value-at-Risk to measure daily losses that can occur at designated standard deviation intervals. They were certainly knocked down a few pegs when they tried to change to a new model and had to revert to the old one because the risk of the large credit derivatives trades were not reflective of reality.

Stock markets took out their frustrations on JPM stock, knocking it down close to $30 billion in market capitalization, before it began to recover; year-to-date, JPM stock is up 7.5%. Congress hauled Dimon to Washington to testify about the losses; as ever, he handled himself with authority and remained feisty. The end result will likely be more overzealous financial regulation. But, hey, at least J.P. Morgan, Dimon, and the London Whale took some of the attention away from the surprising Facebook IPO fiasco.

More Yield Curve Manipulation

The Federal Reserve is at it again. As I wrote last quarter, the Fed continues on their campaign to artificially push long term rates lower. They continue on with their “promise” to keep short term rates at exceptionally low levels until the end of 2014. And in June, they announced that they are increasing their “Operation Twist” $400 billion program, where they are selling shorter term securities and buying longer term securities, by an additional $267 billion through December, 2012. This will continue to keep downward pressure on longer rates, such as five through thirty year maturities.

Inflation continues to run at about 2%, with long term expectations at about 2.1%. Treasury yields continue to decline, with the 5 year currently at 0.70% and the 10 year at 1.60%. Granted, the Federal Reserve is not the only presence pushing long term rates lower; weakening economic data throughout the second quarter and the flight to quality with investors buying safe haven Treasuries to park funds safely during the European crisis both contributed to lower interest rates.

Mortgage rates are falling to all time lows along with Treasuries. My biggest fear is that the Fed is sowing the seeds of the next crisis with their flatter yield curve tricks, leaving many investors holding these low yielding long bonds when rates rise in future years, unable to get out without substantial capital losses.

Déjà vu

For the third year in a row, we are seeing economic growth slow into the second quarter. Job growth has noticeably slowed and the unemployment rate inched up to 8.2%. Oil prices spiked above $100 per barrel and gas prices spiked to about $4 per gallon early in the year two of the past three years, including this year. Nothing puts a damper on consumer spending quite like high energy prices. Consumers reach a so-called “tipping point,” and cut their spending.

The only situation worse, of course, is unemployment and we have seen a dramatic slowdown in payroll growth to under 100,000 per month for April and May, down from the stronger pace of over 200,000 per month in the first quarter. So it’s déjà vu again.

Economic releases have been mixed during the second quarter, with the aforementioned slowing of job growth causing economists to lower their GDP growth forecasts for 2012 and 2013. In June, the Federal Reserve, with their thousands of economic analysts, lowered their projection for 2012 by 0.5% to a range of 1.9% to 2.4% and for 2013 by 0.4% on average to a range of 2.2% to 2.8%. It’s hardly encouraging. Isn’t this déjà vu, too?

When the final GDP first quarter 2012 figures were released during the last week of June, corporate profits were revised to a decline of 0.3% in the first quarter, which was the first drop since the fourth quarter of 2008. This explains some of the stock market decline as earnings were being released during April and early May and were coming in weaker versus the prior quarter.

Déjà vu can signal positive things too; in the last three years, we saw economic slowdown, not recession, in the spring and summer, and then slight recovery into fall and winter. That pattern should hold again, given how much stimulus is in the economy from the Federal Reserve. So much this quarter has been surprising that I can hardly wait for the third quarter to begin, although I would prefer not to be in the midst of another heat wave on the east coast.

Stay tuned!

Thanks for reading! DJ 07/01/12

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.