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Behind the Fed's Policy Leak

A front-page WSJ story, “Fed Mulls Symbolic Shift,” is a great leak from the central bank to reporter Jon Hilsenrath. Basically, the Fed wants to stop its $2.3 trillion balance-sheet portfolio from shrinking and therefore tightening monetary policy. So, when its mortgage-bond holdings mature, the Fed would take the principal and interest and go into the open market to replace the bonds. This would keep the Fed’s holdings flat, or stable, rather than have the holdings run off.

Inflation-sensitive markets did very little on the news yesterday. Gold was up slightly to $1,189, and the trade-weighted dollar continued its recent drop by about half a percent to 80.6.

What’s really behind the Fed move -- if the central bank announces it at its mid-month FOMC meeting -- is fear of an economic slowdown. The Fed doesn’t want to be seen as tightening its policy. The target rate is near zero already. But the balance sheet is the key to money creation.

Noteworthy is the fact that the monetary base has been flat-lined at $2 trillion for about 10 months, going back to last October. In sound-money terms, it would be okay with me if the Fed held the monetary base steady for a long, long time. That would keep the dollar stable and would probably keep gold prices steady. If investors actually believed in a stable policy, perhaps the greenback would rise while gold fell.

But alas, Bernanke is still engaged in economic fine-tuning rather than dollar value. We have no exchange-rate policy. Nor is there a gold policy. So no one could possible know where these prices are going.

Thinking back to Robert Mundell’s original idea years ago, an optimal policy would include low marginal tax rates and a steady dollar backed by gold. But marginal tax rates may go up, the dollar is not backed by gold, and the fate of the greenback is anyone’s guess.

Meanwhile, buying more bonds to create new cash for the economy is futile. There’s already $1 trillion of excess bank reserves on deposit at the Fed. In other words, the financial system has more dollars than it knows what to do with.

The economic recovery and job creation are being held back by tax and regulatory obstacles, not by a shortage of money. It’s fiscal policy that is wrongheaded. But then again, without a strong-dollar policy, no one can really give the Fed any kudus either.

Is Today's ADP Employment Report A Positive Precursor to Friday's Jobs Numbers?

The market is slightly higher in early trading after a couple of better than expected economic reports, and some more strong earnings.

Last night, Priceline (PCLN) reported very strong earnings and guidance, and the stock has surged +20% higher in early trading, up $50. Why did we sell that one again?!? Oh yeah, something about a slowdown in Europe hurting their business. Ugh.

In economic news, the ADP Employment report came in better than expected showing 42,000 jobs were added to the private sector in July. This report doesn't always correlate well with the govt. payrolls report (due out Friday), so we'll have to see if Friday's numbers top the consensus as well. Right now, estimates for Friday's payroll report is for a loss of 100,000 jobs.

Also, the ISM Services Index for July came in above expectations at 54.3, up from last month's reading of 53.8.

Asian markets were mixed overnight, and Europe is lower this morning. The euro is finally lower today, boosting the dollar. Commodities are mixed; oil prices are down a bit to $82.20 after a big rally yesterday, and gold prices are higher, back near the $1200 level.

The 10-year yield is again trying to bounce from those low 2.90% levels, currently higher to 2.95%; and the volatility index is just slightly higher at 22.73.

Trading comment: Yesterday I mentioned that I wanted to see the S&P 500 hold the 200-day average above 1114, and that is exactly what happened. We'll see how today goes, but if we can hold around these levels, I think it puts the market in good shape for another move higher, and above the June highs (SPX 1131).

Friday's employment report is always a wildcard, and can cause some volatility in the market. But overall the action is constructive, and favors the bulls at this juncture.

Stocks Pull Back After Yesterday's Rally

The market is a bit lower in early trading after a couple of soft economic reports and some earnings misses as well.

Most earnings reports have come in strong this reporting season, but today Proctor & Gamble (PG) and Dow Chemical (DOW) both came up short of expectations, and their stocks are lower as a result.

In economic news, factory orders for June were also below expectations at -1.2% (vs. -0.5% consensus). And pending home sales for June decreased -2.6%, but that was actually better than forecasts.

This morning's pullback likely also has some profit taking going on as well. If this news was out yesterday, it probably wouldn't have halted the rally. But today the tone is softer, and so these types of news hitting the wires get used as an excuse to do some selling.

Asian markets were mixed overnight, with Japan rallying but China falling after reports that there could be further increases to bank reserve requirements in China. I have to admit, there are a lot of cross currents coming out of China, making the bull/bear debate between a soft landing and further tightening very difficult to handicap.

The dollar is lower again, extending its recent slide (which is getting long in the tooth). This is helping boost commodities, with oil prices higher to $81.50 and gold still hovering around $1187.

After a brief one-day bounce, the 10-year yield is back down to testing the 2.90% level. The volatility index is also at low levels, up slightly today to 22.33.

Trading comment: Yesterday's action was very strong, and market breadth was positive. The major indexes are now back into positive territory for the year. Looking at the oscillator chart below, the market is now back into overbought territory, so I would not be surprised to see some backing and filling in the near term.

The S&P 500 is now above its 200-day moving average, which currently sits near 1114. Ideally, this 1114 level will now act as support, and after the market works off its current overbought condition, we will see more upside ahead. Ideally being the key word.

Dave Stockman Totally Backed Down

Dave Stockman totally backed down on his assault against supply-side tax cuts, but he’s given up on the fight to curb spending and entitlements.

Monday Morning Musings

The market is sharply higher in early trading, following strong overseas action. Asian markets were higher overnight after China's PMI report showed a little cooling, which eased fears of tighter monetary policy. In Europe, upbeat earnings from some of their largest banks helped boost markets.

Here in the U.S., the ISM Manufacturing Index for July rose to 55.5, better than the 54.2 that was expected.

The dollar is lower again, and this is helping boost commodities. Oil prices are above the $80 level near $80.85; and gold prices are up a bit to $1187.

Among the sector ETFs, energy is leading the way (+3.0%), followed by materials (+2.20%); consumer staples are lagging (+0.85%), but all 10 major sectors are higher.

The 10-year yield is bouncing from Friday's of the 2.90% level, currently up to 2.95% (which is still a low level overall); the volatility index is down -4.85% to 22.35 currently (last week's low was 21.86).

Trading comment: Last week I suggested that if the S&P 500 could just consolidate in a benign fashion after running into resistance at its overhead 200-day average, that it would probably be in good shape to make another stab at it. Today that is what we are seeing. The SPX has spiked through that level (currently at 1114). This is very positive action. And market breadth is solid with upside volume levels running near 90%.

Additionally, the S&P if it stays up here is now back into positive territory for the year. That will start to put increasing pressure on portfolio managers to put cash to work to continue to keep pace with the averages.

The Flaws in Dave Stockman's Thinking

My former boss Dave Stockman blames Republicans and supply-side tax cuts -- rather than big-spending by the Democrats -- for our debt problems and (by inference) the weak economy. I disagree.

We have a bipartisan spending problem, largely driven by entitlements over the long run and ineffectual stimulus in the short term. Stockman seems to want to solve the spending problem with higher taxes. Some recent estimates suggest the need for an 80 or 90 percent tax rate to do that. But what would it do to the economy? Or global competitiveness?

We’re not going to tax our way out of the entitlement quagmire. That’s the fundamental flaw in Stockman’s thinking.

By the way, in the ’80s and ’90s, the debt-to-GDP ratio averaged around 40 percent. Nothing destructive there. Reagan’s low tax rates, which on balance were maintained during the Clinton years (Clinton raised the top personal rate but signed the Republican bill to lower the capital-gains tax rate), generated a long boom of 3.7 percent annual growth, 39 million new private jobs, and low inflation.

I agree with Stockman that Paul Volcker was the great inflation killer. Absolutely. But lower tax rates helped spur growth while Volcker brought down the money supply and stabilized the dollar. In fact, gold basically declined through the whole period, while stocks went up. Government debt held by the public did increase $2.4 trillion. But household wealth jumped $32 trillion.

Incidentally, budget spending as a share of GDP declined during the whole period, from near 24 percent to around 18 percent. Much of that was during the Clinton years, when the president worked with the Gingrich Congress. And a lot of the spending restraint came from the peace dividend after the Soviets folded and defense spending was cut.

Now, Stockman is more on target when he says Bush and the GOP overspent and created new entitlements. But blaming Bush’s tax cuts for the Great Recession and for dropping revenues to 15 percent of GDP is utter poppycock. Of course, Obama is overspending even more, with still more entitlements.

The truth is that spending on entitlements and a stimulus that didn’t really work has made for some truly horrible long-term debt projections. So let’s address the spending instead of jacking up tax rates.

And let’s not forget that tax rates are coming down around the world, both for individuals and businesses. High tax rates in the U.S. will cause us to lose the global race for capital. At some point the question of taxes is really an issue of economic freedom. Let people keep more of what they earn. Marginal tax rates produce huge incentive effects for work, investment, and risk. Higher tax rates undermine economic growth and entrepreneurship. So let’s go for tax reform, with flatter rates and a broader base that gets rid of unnecessary deductions, credits, exemptions, loopholes, and special-interest subsidies.

The goal of policy should be to limit spending and taxes.

Now, I really do agree with Stockman when he fingers the Fed’s erratic stop-and-go monetary policy over the past ten years. Re-linking the dollar to gold or some commodity standard to impose financial and trade discipline is a very good idea. Putting limits on financial leverage is another good idea.

But I would say to my former boss Dave Stockman: You know there’s a spending problem. Let’s tackle that without crippling the economy.