Taking A Punch
Many things have happened since I last wrote, on the day of CPI.
Libya declared a cease-fire. Libya immediately violated its own cease-fire. A number of nations, including but not led by the U.S., imposed a no-fly zone in Libya at probably the last possible moment before the rebels faced defeat, and now may seek to secure the country by attacking Gaddafi's troops by land. A member of the U.S. President's own party declared that he should be impeached. Oil, seemingly oblivious of this drama, traded up another $4 over that time period and is near the year's highs. I paid $72 to fill my Jeep today.
Existing Home Sales were dismal, and inventories actually rose slightly for the first time in six months. This is a small surprise given the low rates and slowing improving economic situation, but it may also be an insignificant wiggle. Still, economists have been revising lower their projected growth rates for Q1. Growing, but not booming.
The Treasury announced that it is going to sell "up to" $10bln of its $142bln portfolio of agency MBS per month. This is prudent since they are aware of a $1.25 trillion portfolio that supposedly wants to unwind over the next few years (I seriously doubt it will happen). The timing is good since there is no net Treasury issuance at presence, thanks to the fact that the Fed is buying all of the net paper. It is not a monetary drain the way it will be when the Fed sells securities, because in the Treasury's case it is replacing other issuance that it would do. The money will be spent either way! When the Fed sells securities for cash, the cash just sits there. When the Treasury sells securities for cash, it is recycled into the economy in the form of spending.
Portugal's government looks poised to lose a vote in parliament, and the event would effectively topple the government and push early elections. J.P. Morgan declared that "the likelihood that the Portuguese government will fall this week looks high." This would, some people believe, force Portugal to seek support from the Stability Facility. If that surprises you, then you haven't been paying much attention. Portuguese 10y yields are at 7.38%, below Ireland's 9.66% partly because Irish yields keep rising. And yet, we keep hearing that the ECB is preparing to tighten monetary policy. If I was in Ireland, Greece, or Portugal, such talk would really irritate me. Slowing the economy right now is not exactly what these guys need, especially since the European economy is currently growing at a lusty 2% y/y. If there is a risk to the inflationary outcome being stoked by the Fed and perhaps finally the BOJ, it is that the ECB makes a horrendous policy error and tightens policy into a weak economy. I didn't think this was very likely, because only fools would be thinking about tightening in Europe right now. It's like taking someone on life support and deciding to remove their appendix. Without sterile equipment.
In an unrelated note, probably, Venezuelan strongman Hugo Chavez declared that capitalism may have ended life on Mars. He may have been joking.
Japan has gotten the nuclear situation seemingly under control, and the world is breathing a sigh of relief. The scale and scope of the catastrophe is still staggering. Some 9,000 people are confirmed dead, and with the number still missing and the number still without heat or food that number could still double. Into this great tragedy, the Bank of Japan and other central banks jointly intervened to weaken the yen several days ago. This is even less explicable than the saber-rattling of the ECB, because at least that could be stopped at saber-rattling. Why in the world would you want to weaken the yen? The fact it is strong is incredible in the first place - ordinarily currencies of countries with weakening economies, huge deficits, and loosening monetary policy will weaken on their own. A lower currency, induced by central banks, means that the people of Japan will have higher prices to deal with in addition to everything else, and since Japan imports most of its food and energy it means higher prices for those things. It helps the export sector, but right now they're not making much of anything so it's all downside.
Okay, now I think we are caught up as we head into Wednesday's New Home Sales (Consensus: 290k from 284k) data. The bottom line is this: the immediate, nuclear crisis of Japan has passed. The Libya/MENA/energy price crisis is upon us. The Portuguese crisis is yet to occur.
The economy is no longer in recession, and is strengthening slowly. But what we don't know is, can the economy take a punch? A robust, healthy, free-market economy can adjust to the vicissitudes of life on this big blue marble. In 1987, the global equity market crash happened when the economy was otherwise strong, and after some wrenching losses life continued more or less normally. In 2000, the market crash hit an economy that was already overextended and weakening, and the terrorist attacks in 2001 kept the economy on the canvass for another year.
I don't think there can be much debate that punches are coming. They're always coming. The biggest problems we have tend to be when the markets price out the possibility of a punch. In this case, we can see some of them coming. The Japanese disaster will have a measurable impact on global GDP and there is a potential for a ripple effect up the supply chain of some products. Oil at $100/bbl is dang inconvenient, but survivable; oil at $125 is a punch we're probably not ready for. And the European situation seems to me to be destined to devolve into a barroom brawl (albeit one where everyone has interesting accents and is speaking very politely while they brandish the furniture).
How will the economy fare, and by extension the markets? I would feel better about the latter if stocks were not priced at a CAPE of 22.9, and if the bond market wasn't being asked to absorb (starting in July) not only the $1+ trillion of new Treasury debt but also to brace for the possibility of absorbing the Fed's balance sheet - at the same time that sovereigns globally are increasingly competing for that capital!