Issue 87 - March 8, 2013


Pulling & Pushing

As the New Year gives way to the tail end of winter, markets are being buffeted by a variety of forces. What had been a welcome calm in market volatility was rousted from its relative slumber by a gridlocked outcome in an Italian election. The sense of progress and coordination toward mending the Euro Zone finances was abruptly shattered by a population which preferred any alternative to the current tough medicine of austerity. Meanwhile, conflicting messages coming out of the Federal Reserve’s January meeting minutes have left market participants wondering if in fact the 19 person committee enjoys a true consensus as to how to best navigate the immediate future and any potential unwind of Quantitative Easing policies. Lastly, earnings for the 4th quarter of 2012 maintained the trend of solid yet unremarkable earnings growth, while the triggering of the federal spending sequester established another headwind for the economy. The amalgamation of these disparate factors had briefly dulled what had been the enthusiasm of the New Year and the avoidance of the “Fiscal Cliff”. However, in the midst of all of this, the Dow Jones Industrial Average has managed to gather itself and rallied up and over its previous high set back in October of 2007.

Where does all of this leave us? Pundits are all over the map. Some argue that we are now in a dramatically improving economic picture with no thought given to the implications for downstream changes in interest rates that such a fact pattern might trigger. Others attribute all forward progress in the markets to the massive expansion of the Fed’s balance sheet and that any withdrawal of their support will result in significant losses in equity prices. Neither of these views is entirely fair to either the progress or innovation of public companies nor to the dynamic nature of a global economy. We are now some 5 years past the initiation of our current financial episode and we can clearly see the signs of demand “pulling” in certain corridors of our own economy. Housing and auto sales are rebounding smartly as credit, while still tight by mid 2000’s standards, is becoming far more widely available and the inventories of both homes and autos have come much more into balance. We have previously touched on the game changing dynamics of US based energy finds and the powerful economic gains which will result from this over the coming decades. We also saw among the various pedestrian earnings reports any number of standouts where managements have just done a better job of running their operations relative to their competitors both here and abroad. The challenge for investors is to understand and accept the natural unevenness and lengthy duration of a recovery from a financial shock. This has not been a garden variety slowdown that lower rates would have already corrected. There were never any “green shoots” or “escape velocity” signs 12-18 months out. This has been and will continue to be a slog and we do not have the luxury of losing patience or discipline.

The Federal Reserve has been involved in non traditional, open market operations since the fall of 2008. The process known as Quantitative Easing includes large purchases of US Treasuries and mortgage backed securities of various maturities. It is designed to effectively drive rates mathematically “below zero” (an interesting concept) when actual zero rates are failing to incent sufficient interest in borrowing. However, the reason zero rates might not be working, is that when you come out of a financial shock which was driven by overwhelming leverage, the last thing anyone wants is more debt – even if the use of the money is effectively free. Carmen Reinhart and Kenneth Rogoff, document 8 centuries of similar crises in their book, “This Time is Different” and demonstrate that the typical trajectory of recoveries coming out of these chapters are long and shallow no matter how cheap money might have become. Therefore, the Federal Reserve’s continuing purchases are viewed by some as pointless as the exercise of trying to “push on a string”. It can’t be done. But this begs the following question. If the Fed’s “pushing” is not helpful, how then is their not “pushing” detrimental? Low rates are undoubtedly helpful, but they are not in and of themselves sufficient to increase demand or employment or inflation for that matter. Real economic growth will be required.

They are many legitimate concerns surrounding the Federal Reserve’s QE programs. The dousing of traditional market signals through the suppression of rates could lead to new and potentially larger bubbles. There is also the “Financial Repression” impacting savers and fixed income investors who can no longer find relatively risk free sources of suitable income. The latter is of course the primary modus operandi of the Fed’s policy: to drive investment into more risk based assets thereby rekindling growth by denying all other options. However, it is the possibility that all of this massive liquidity will drive rampant inflation when it re-enters the market that causes the most concern.

There are two points to consider in this matter. First, is the fact that all of this liquidity is currently sitting dormant. The banks are simply not lending at a pace that would begin to draw these balances out of the Fed. This is demonstrated by the velocity of money which you can see has gone missing.

The second regards the Fed’s actions and the “inevitable” unwind of all of the QE purchases, which has ballooned the balance sheet of the Federal Reserve from some $750 Billion prior to this period, to over $3 Trillion today. Much has been written about what the tsunami of inventory could do not only to market rates (send them much higher) but also to the value of the Fed’s remaining holdings (drive them way down). But perhaps there is another possibility. The committee could taper down and eventually discontinue their purchases over time and then not sell their portfolio.

Deus ex Machina

Ancient Greek tragedies were known to employ mechanical devices to raise or lower actors playing gods onto their stages in an effort to solve an intractable problem. This unexpected path to resolution was known as “Deus ex Machina”.

The Federal Reserve is under no obligation to sell their existing positions at any time. There is no mark to market requirement or stipulation that they recognize any such losses while they wait for their holdings to mature. Ben Bernanke spoke to this very point in his recent congressional testimony. They could simply allow the position to roll off, which would take some time as their average maturity is now north of 8 years. But again, thinking in terms of years rather than in months or quarters is probably more appropriate. The DV01 or dollar value of each basis point is now some $3 Billion dollars on a balance sheet of this size. That’s real money by even the Fed’s standards. But who controls interest rate policy? The Federal Reserve historically controlled short term rates but these non traditional and globally coordinated efforts have now extended their influence to much longer rates. The possibility now exists that the Federal Reserve would keep rates low for a long enough period to not only hand off the responsibility for a continuing economic recovery but to also allow a reasonable portion of their holdings to mature. There would be in fact no “exit”, just a tapering of purchases leading to an eventual unwinding of the balance sheet.

Perfect as the Enemy

We are clearly living through a confusing set of market signals. Modestly improving economic data is competing against a backdrop of higher tax burdens and slowing government spending. As Jim Bianco noted this week – “we do not have an Honor Roll type of economy”. Ray Dalio of Bridgewater Associates commented in a widely watched January 24th interview from Davos, Switzerland – “we came very close to having chaos….we got past that point. So now as we move forward, we can, - that can be managed.” Lastly, David Rosenberg in his February 15th daily missive commented, “what Ben Bernanke is telling is that for the greater good of trying to deploy $9 Trillion now sitting in bank deposits, mattresses and T-bills, he is going to penalize acute risk aversion”. Taken together, these three opinions reflect the reality of an economic backdrop which is far from ideal, but that has improved structurally from the depths of the 2008 crisis and that the posture of the Federal Reserve is likely to remain accommodative toward risk assets for quite some time. In addition, we should always remember that we do not invest in a vacuum. The actions of the ECB and the Japanese Central Bank have been highly coordinated with our own. This is another way of saying that the environment that we are in, and as odd and uncomfortable it may seem, is going to continue to be our not so new normal. Such a backdrop demands that we maintain our focus and discipline on quality in growth assets and risk adjusted income opportunities.

Best Wishes,

Jen & Patsy


In this Edition

  • Pulling & Pushing
  • Deus ex Machina
  • Perfect as the Enemy

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

86 - 01.04.13
The Fiscal Alps/ The Paradox & the Rub/ Next up - Zero Rates Forever/ 2013: Promises & Plausibility/ On a Positive Note

85 - 12.13.12
Giving Sausage a Bad Name/ Drowning in a River 2 Feet Deep/ Scarcity in US Treasuries

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward



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Market Highlights

6/29/12 3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
13,104 12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,426 1,362 1,408 1,258 1,258 1,115
Nasdaq US
3,020 2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,604 1,423 1,553 1,413 1,658 1,581
5 Yr Treasury .89 .74 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni .81 .9 .86 1.03 .94 1.75
10 Yr Treasury
1.81 1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
1.99 2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 3.196 2.94 2.78 3.33 2.914 4.325
30 Yr AAA Muni 3.16 3.16 3.56 3.72 3.82 4.9
EUR Currency 1.30 1.32 1.26 1.33 1.29 1.34
JPY Currency 94.15 86.10 79.49 82.08 77.36 81.32
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