The Cliff Has Arrived

Well, just when we thought the country was going to receive a special present for Christmas, it turns out the Grinch has other plans. It looks like we have arrived at the “Cliff” and we're going over it. It’s unfortunate but speaks to the state of affairs in Washington.

It's really too bad that a Republican or Democrat elected in New York (for example) to represent those state’s issues has to become part of their party’s voting block as soon as he or she arrives in DC.  Each state's representaive has a whole different set of priorities and concerns based on that states constituents.  However, once you arrive in Washington, you can’t think for yourself, vote on your own, or work with the other party to solve an issue facing the country because you have basically joined a tribe, and tribes don’t like other tribes.

The reason we have a fiscal cliff is because Washington has become tribal. To members of Congress, your tribe is more important than your country and keep your position in the tribe is second. It used to be true that people regarded a stalemate in Washington as a good thing, but this time the fiscal cliff was supposed to force action and good ole fashion compromise.  Sadly this didn't happen.  Is there anything the American people can do to breakup these two tribes? The contempt for Congress is readily seen in the low approval ratings, but most people seem to think their own representative is doing a good job.  Even though we probably should have voted them all out this past November, we didn’t.

As the host of Survivor often says - “The tribe has spoken.”

Sadly, the only way to force action on Congress is for the markets to drop in order for members of Congress and the Senate to begin to feel a sense of urgency to get a deal done.

This is not a good way to end the year.

FED Rate Decision

Below is an excerpt from an article published by Marketfield Fund on the Federal Reserve meeting held this past week.  While the language in the most recent statement has changed, the Fed's goal of providing plenty of liquidity has not.


"Just because something is expected does not mean that it is not remarkable, and the blithe nature with which the FOMC has ushered in two changes to monetary policy should not hide the radical nature of these changes. We assume that the FOMC waited until after the election to alter policy since, although the FOMC is nominally independent, it is also politically sensitive.

December's meeting has had two substantive outcomes; first, the FOMC elected to extend asset purchases after the expiration of Operation Twist. Starting in January, what had originally been a program of maturity extension designed to lower long-term treasury rates has now morphed into additional quantitative easing. The FRB will now purchase an additional $45 billion of long dated Treasury securities but will no longer sell short dated paper to sterilize these flows. This will come on top of the $40 billion of MBS purchases, meaning that the FRB's balance sheet will now grow at $85 billion a month, which would be an annualized rate of 35% based on the current size of the balance sheet.

This is despite the fact that since Chairman Bernanke's Jackson Hole speech last August, overall economic data has been robust, including the key employment metrics. Most obviously the unemployment rate, which has clearly been elevated into the statistic of the current monetary cycle, has fallen from 8.3% (using July's data) to 7.7% since this speech was made.

This brings us to the second and arguably more radical shift in policy. Rather than issue guidance based on a date for anticipated change in policy, the FOMC has started to tie policy explicitly to an unemployment rate, with inflation concerns coming in as a distant second, stating that current policy will remain in place:

"At least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

"The Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."

However, in our experience, the market will pay much more attention to the first of these paragraphs, with asset prices now being very sensitive to the monthly unemployment rate, despite the fact that this is one of the least reliable metrics in the monthly data calendar. Moreover, our belief is that unemployment may continue to surprise observers by trending lower for the remainder of the favorable data season (which will continue until March). Although it seem highly unlikely that the magical 6½% could be reached by then, we could find ourselves close enough to 7% that the bond market starts to twitch nervously that the 2015 guesstimate for the expiration of current policy may be unpleasantly inaccurate.

In the meantime, the continued bloating of the FRB's balance sheet is really a signal to investors that the FRB is determined to force a recovery at all costs. Although the FRB is injecting substantial capital into long dated treasury and mortgage bonds, we assume that the success of this policy will ultimately come at the expense of the bond market. In particular, longer dated yields really should start to move higher as private capital starts to get the message that the FOMC is prepared to rewrite the rules as many times as it takes to win the game."