Guest Post: Year End Economic Commentary by Dorothy Jaworski

2014’s Biggest Surprise

It never fails.  The markets provide us with completely unexpected surprises and leave us scrambling to update our projections for rates and economic growth.  And so it was in the latter part of 2014.  Oil prices began a massive plunge, down 46% for the year to $53 per barrel.  And who expected this?  Well- no one.  Now we all have to adjust to this new reality.  What are the implications of the crash in oil prices?  And why did they plunge?

We all have been reading for years how the United States was dramatically increasing energy production, especially from a method of extracting oil and natural gas in shale regions of the country known as hydraulic fracturing or “fracking.”  Suddenly the US was the world leader in oil production.  Suddenly the world realized that there was a supply glut.  OPEC members and Russia stand to suffer the most from lower oil prices, but have continually sworn to keep production at current levels, perhaps using low prices to stall US investment and production.  While the US economy is growing slowly and steadily, this is not the case in China, Europe, and Japan, who are experiencing low growth, no growth, and outright recession, respectively.  This is a recipe for weak demand which, when combined with a supply glut, means lower prices.  Also, the US dollar has been strengthening, with a 12% increase in 2014, further pushing oil prices lower as oil is typically traded as a dollar denominated commodity.

Think back, too, as to when oil prices were close to $100 per barrel earlier in 2014.  Geopolitical tensions were running rampant as fighting was ongoing in Israel-Gaza, Russia-Ukraine-Crimea, and Syria with ISIS stepping up as a huge threat.  Supply disruptions were the typical fear but the tensions have since subsided.  These tensions could reappear if unrest rises in Russia, Iran, Saudi Arabia, Venezuela, and other countries that are highly dependent on oil for revenues.  Now US consumers can be the biggest beneficiary of falling gasoline prices, which recently peaked at $3.69 per gallon in April, 2014 and ended the year at $2.23.  Consumers rejoice!  And don’t forget that heating oil prices have plunged, too, just in time for another polar vortex.  I have always believed that cheaper oil and gas prices are like a tax cut that helps consumers save money on their “taxes” and spend it on other discretionary goods and services.  I was gratified to hear Janet Yellen reiterate this same point.  Consumer can and will rejoice and spend.  Economists revised their projections to include new assumptions that consumers will save between $70 billion and $100 billion annually on gas and will spend most of the savings, perhaps increasing real GDP by at least a net +.5%.  Yeah, finally!  A 3% GDP number! Happy 2015!

The Economy in 2015

Most economists were projecting +2.5% in real GDP growth in 2015, prior to the windfall from plunging oil prices.  As mentioned, they have increased projections to +3.0%.  Over the past five years, GDP has averaged +2.2%, which is quite disappointing compared to the average growth of +4.6% for the past ten recoveries.  If we make it to +3.0% in 2015, it will be the first time in six years of recovery that we have touched +3.0%.  Perhaps that is why former Federal Reserve Chairman Alan Greenspan just proclaimed that “we still have a sluggish economy,” which will not fully recover until there is more investment in long lived, productive assets and the housing market recovers.  Despite all the euphoria over a lower unemployment rate of 5.8% (down in 2014 from 7.0%), the fact that many of the jobs created have been part-time, lower wage ones and many experienced workers are dropping out of the labor force.  I do see millions of jobs being created in 2015, but still many are part-time, thanks mainly to Obamacare and other regulations.

Who projected that interest rates would fall in 2014?  Well- no one- except maybe Dr. Lacy Hunt of Hoisington Management, who has been on top of trends most of us do not see.  I read his quarterly newsletters with great interest and you should, too.  The ten year Treasury yield topped 3% at the end of 2013 and fell to 2.20% by the end of 2014.  Why?  Falling inflation and falling inflationary expectations will do the trick.  Falling inflation confounds the Philips Curvers, who read their textbooks and expected higher inflation from the falling unemployment rate.  I’ll bet John Taylor is a little upset, too, with trying to use inflation in his Taylor Rule formula.  Weakness in most world economies other than the US is keeping inflation under control with weak demand- especially as seen with commodity prices.  US rates continue to be substantially higher than rates in Europe and Japan with less risk.  That upsets me, because it is not normal.  Yet, the Federal Reserve stubbornly continues to proclaim that they will raise interest rates by mid-2015.  I say, go ahead.  The Fed will just end up lowering them shortly thereafter when they realize they have tightened prematurely.  New York Fed President William Dudley recently warned of just this risk, when he spoke of the historical classic case of premature tightening in 1937 by the Fed, when recession and deflation followed.   

Risks to Growth

I’m an optimist at heart, but I feel obligated to point out the risks to economic growth.  Measuring and managing risk has been my specialty in a banking career that is now 40 years old, of which 29 years have been spent dealing with risk.  The aforementioned risk of a Fed policy error of premature tightening tops the list.  Economies around the world are struggling and their policy makers are still easing monetary policy, making the spread between US rates and those economies’ rates unnaturally wide.  The ever rising US dollar could contribute to weaker and weaker currencies around the world, leaving countries to struggle and have to raise rates.  We have geopolitical (the word made famous by Greenspan in the early 2000s) risks of war, terrorism, epidemics such as ebola and influenza, and cyber attacks.

And there are two more risks that are not getting a lot of press- deflation- which can lead to deferred demand, declining wages, and slowing GDP- and liquidity risk- where restrictions and regulations have nearly strangled the life out of financial institution market makers, who seem increasingly unwilling or unable to take bonds into inventory and hedge them, instead opting to act like brokers, taking too much time to execute trades and too wide a bid-ask spread.  Market makers are not alone in this regulatory nightmare; 79,000 proposal and final rule pages were published in the Federal Register in 2014 affecting all industries, with a cumulative total of 468,500 since the recovery began in 2009.  Once again, I digress.  But, that’s what I am here for.  Stay tuned!  

Thanks for reading!  01/05/15


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. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure.

Guest Post: 2012 Economic Year in Review by Dorothy Jaworski

Looking Back at 2012

Every year, I usually write about the past year with mixed feelings, at times nostalgic for those events and at times, glad that the year is over. 2012 brought us highs, lows, and surprises. As to the latter, the Federal Reserve is always good for a couple of surprises. They continued to run their easing campaign, now going on six years strong and counting, pushing down on Treasury yields, spreads, mortgage rates, and pushing up on money supply. The result has been high bond prices, historically low rates, with the 10 year Treasury ending the year at 1.73% (below most inflation measures!), more “promises,” and a constant flow of new money into the markets.

The biggest beneficiary of all this Fed activity has been the stock market—which ended the year at some pretty good “handles,” with the Dow above 13,000, S&P 500 above 1,400, and the Nasdaq above 3,000. Price gains for the year ranged from just over 7% for the Dow to almost 16% for the Nasdaq. Stocks remain an attractive asset class with the dividend yield of 2.2% on the S&P 500 exceeding the yield on 10 year Treasuries of 1.73%. 

Housing markets have begun to improve with the national indices showing year-over-year growth of 3% to 4% recently. We have a long way to go before recapturing the home price highs of 2006 and 2007, but it is a start. Auto makers continue to enjoy their rebound, with the Big 3 US Automakers enjoying their best month in December, 2012 since the Great Recession took hold. Gas prices are finally coming down, making people able to drive their brand new cars more; I am glad to be testing the $3.00 per gallon price level rather than the $4.00 one.

The dominant theme of 2012 was the Presidential election. Over $2 billion was spent by both campaigns and nothing changed. I don’t know about you, but I want my money back! That $2 billion pales in comparison to JP Morgan’s losses of $6.2 billion so far from trading of credit derivatives by the London Whale. Boy, wasn’t Jamie Dimon humiliated when he found out it was more than a “tempest in a teapot!” 

Superstorm Sandy battered the coasts of New Jersey and New York with devastating results. Another of the year’s lows was watching our lawmakers and politicians argue until midnight on New Year’s Eve over the “fiscal cliff” and vote in the wee hours of the morning to “save” us. A new low, indeed, but more on that later.

The Fed—At It Again

The Federal Reserve keeps experimenting with their monetary policy moves, continually trying something new without waiting to see how the past moves are working out. In December, they announced that they would change their “promise” from keeping rates super low through the arbitrary date of mid-2015 to a “promise” to keep rates super low as long as unemployment exceeds 6.5% and core inflation between one and two years out is less than 2.5%, with inflationary expectations well anchored. So in effect, they have changed to a performance based measurement system that may not manipulate the yield curve as violently; this is clearly an improvement over the “pick-a-date” strategy. They could have included GDP growth as a benchmark; they will figure that out later and add it, I’m sure.

The Fed continues to buy bonds and more bonds. They announced another quantitative easing program—this time, QE3—part 2, in which they will buy $45 billion a month in Treasury bonds in addition to the $40 billion per month of mortgage backed securities that they are buying for QE3. Yes, folks, that would be $1 trillion per year! Since QE3 is open-ended, we have no idea how large it will grow. My thoughts are that, someday, they will want to sell the $2 to $3 trillion of bonds that they have accumulated in all of their QE programs. Nobody can buy that many bonds. Ben Bernanke probably does not have to worry about it; he has telegraphed his intention not to serve another term when his current one expires early in 2014. Who will bring Happiness then?

The “Fiscal Cliff”

Who in their right minds would have so many critical tax codes and laws expiring all on  the same year-end date? Oh, wait, our Congress! Once again, we saw the mad scramble to prevent a “crisis” and the secret meetings to get a deal done at the midnight hour. In the early morning of New Year’s Day, the Senate voted to pass legislation to make permanent most of the lower Bush tax rates, adjust deductions, extend unemployment benefits, continue tax credits and tax breaks, and, for some, just plain raise taxes. 

The stock markets rejoiced and rallied 2% to 3% on January 2nd, because the fiscal cliff was now manageable, not an apocalypse. Higher wage earners will see an increase in the top tax bracket, from 35% to 39.6%, and an increase in their capital gains and investment income levels from 15% to 20%. All workers will be impacted by the expiration of the payroll tax “holiday,” which means the Social Security tax goes from the temporary level of 4.2% to its original 6.2%, translating to an extra 2% tax to be paid in 2013 for 77% of households, costing them about $110 billion more in 2013 than 2012.

Aside from the secret negotiations and last minute crisis atmosphere that surrounds Washington DC, overall, it is a good thing that the cliff is resolved for now. The tax bracket changes become permanent and that will allow planning to resume. The estate tax exemption was raised to $5 million per individual. A permanent fix was placed into the tax code to index the AMT tax and save tens of millions of taxpayers from one of the more evil tax code provisions. 

The original estimates of the economic damage from the cliff were over $600 billion for the year in higher taxes. With the deal and the passage of the American Taxpayer Relief Act of 2012 on New Year’s day, the damage will “only” amount to about $160 billion (from the 2% rise in Social Security tax and higher taxes and capital gains/investment income on higher income taxpayers- $400,000 for individuals and $450,000 for couples). The estimated reduction to GDP would be -.3% to -.4% in 2013, rather than -1.2% for the whole cliff.

Spending cuts were not addressed in this latest deal. In fact, the sequestration cuts of $1.2 trillion over 10 years that were mandated to start on January 1st were postponed by two months. Isn’t that always the way? Spending will someday have its day of reckoning. We are currently at the debt ceiling limit of $16.4 trillion and the US deficits keep running at over $1 trillion per year, or about 8% of GDP. The debt of $16.4 trillion is well over 100% of our GDP, which should bring on more concern, especially as we watch our European friends deal with the same issues of too much spending and too much debt.

Finally, the IRS is warning that they may not be ready with the revised forms to address the new law in January. If forms are delayed until February at the earliest, there will be delays in filing and receiving tax refunds—you know, those interest free loans so many people grant the government each year. The average refund last year was $3,000, so spending early in the year may be weaker than we would normally expect.

Wrapping It Up

So, every year I talk about a Santa Claus rally. Did we have one? Yes, indeed; the S&P 500 was up 2.3% for the last five trading days of December plus the first two of January and the Dow was up 1.7%. Average Santa Claus rallies typically range from 1.5% to 1.7%. Happiness over the fiscal cliff deal made it happen, I’m sure, because all of the gain came on January 2nd. While there are still tax increases occurring in 2013, at least the deal made the impact a little more manageable. Stay tuned! 

Thanks for reading. DJ 01/04/13

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: 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.