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The Fed, Yellen, And The Debt-Ceiling Debate

  • Written by Syndicated Publisher No Comments Comments
    October 14, 2013

    Over the past several months I have published several pieces on the “risks to the markets”which covered potential catalysts that could derail the rally in the financial markets.  (Seeherehere and here)  Each of these discussions included the risks related to the debt ceiling debate; however, these reports were regularly scoffed at as they did not conform to the mainstream analyst’s bullish commentary.  Even as early as May I wrote “5 Reasons To Buy Bonds” wherein I stated:

    “Coming soon to a ‘kabuki’ theater near you will be the second revival of the ‘debt ceiling debate.’  While I am not suggesting that we will have an exact repeat of the 2011 debacle – it is quite likely that IF the threat of ‘debt default’ begins to surface, once again, interest rates will fall as money seeks a ‘safe haven’ against political turmoil.”

    Of course, as soon as the debt ceiling/government shutdown debate began President Obama immediately started hammering home that the U.S. would default on its debt if the Republican Congress did not immediately raise the debt ceiling and fund the government.  The chart below shows what has happened to interest rates in the meantime.

    10yr-InterestRate-100813

    The simple point here is that IF the financial markets were truly worried about the U.S. defaulting on its debt interest rates would be spiking higher as holders began dumping bonds to protect their capital.  However, the opposite has been the case as investors have bought bonds seeking “safety” against the current spate of market volatility.

    However, the ongoing “antics” in Washington are continuing to weigh on the financial markets by increasing both uncertainty and volatility.  Such environments are not conducive to a market that is stretched fundamentally and technically and is primarily depending on the Fed’s ongoing accommodative policy.

    In this regard the recent nomination of Janet Yellen for the head of the Federal Reserve is certainly notable especially for market bulls.  Bill King of the King Report recently posted theFive Things You Need to Know About Janet Yellen

    1. She has pushed the Fed to use aggressive new policies to boost the economy.
    2. She has a record of being concerned about excessive inflation.
    3. She is a good forecaster.
    4. The financial crisis made her a believer in tougher financial regulations…
    5. She believes in transparency; and the markets think she’s a good communicator.

    However, while she may be ultra-dovish towards continuing the current monetary interventions for an extended period there is a growing chorus of Fed members that are beginning to think otherwise.  The recent release of Fed minutes provided very interesting commentary in this regard (via Zerohedge)

    “… the announcement of a reduction in asset purchases at this meeting might trigger an additional, unwarranted tightening of financial conditions, perhaps because markets would read such an announcement as signaling the Committee’s willingness, notwithstanding mixed recent data, to take an initial step toward exit from its highly accommodative policy…the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market…  it was noted that if the Committee did not pare back its purchases in these circumstances, it might be difficult to explain a cut in coming months, absent clearly stronger data on the economy and a swift resolution of federal fiscal uncertainties…. postponing the reduction in the pace of asset purchases would also allow time for the Committee to further discuss and to implement a clarification or strengthening of its forward guidance for the federal funds rate, which could temper the risk that a future downward adjustment in asset purchases would cause an undesirable tightening of financial conditions.

    Curious that the Fed decided to say the tightening of financial conditions was ‘unwarranted’ – is there a ‘warranted’ market crush and rate surge?”

    The real problem, as we have discussed in the past, is the diminishing rate of returns, economically speaking, of the continued interventions by the Federal Reserve.  There is very little evidence that such programs actually impact the real economy or employment.  This puts Janet Yellen in the precarious position of potentially walking into the “trap” of a bursting bubble created by the years of previous inflations; a fact recently addressed by the head of GM in Canada:

    “The president of General Motors of Canada Ltd. is worried that ultra-cheap auto loans could be causing Canadian vehicle sales to spike just as home sales did during the U.S. housing bubble…”

    This is something worth thinking about. 

    The Debt Ceiling Debate Continues

    The markets were originally very complacent coming into the debt ceiling debate as they believed that the Republicans would quickly “cave” into demands of the democratically controlled Senate and White House.  However, that turned out not to be the case.  Recent poll numbers are certainly not supportive of the President, 58% of Americans do NOT want to hike the debt ceiling with only 37% in favor, which is a huge reversal from the last debt ceiling debate in 2011.

    Furthermore, despite much media coverage to the contrary, the blame for the “shut down” is within the margin of error for a 50-50 split.  However, most of the recent polling was from October 3-6 which was a weekend when Republicans and independents tend to be away or unresponsive.  The 15% to 17% response rate to pollsters drops into single digits on the weekends, with Democrats usually being oversampled

    Despite a rising chorus of voices to the contrary, Harry Reid has requested a $1.1 trillion debt ceiling increase to carry the government through the end of 2014.  However, the reality is that such a debt increase would most likely not get the country through the Spring of 2014 sending us back into a debt ceiling debate just prior to the 2014 elections.  The problem is that the President is adamant that he will not negotiate over with Congress over the debt ceiling.

    “President Obama called Speaker John Boehner (R-Ohio) on Tuesday to say he would not negotiate on the debt ceiling…Obama pressed Boehner to allow ‘timely up-or-down vote’ to raise debt limit ‘with no ideological strings attached.’

    However, with polls favoring the Republicans at this point, Congress is becoming much more emboldened in their stance.  This debt ceiling debate has officially become a game of“chicken” with the loser being whichever side blinks first.   The sad part of this commentary is that in 2006, when the Federal debt level was roughly $8.3 Trillion, then Senator, Barack Obama in a floor speech stated:

    “The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. government can’t pay its own bills. … I therefore intend to oppose the effort to increase America’s debt limit.” 

    Today, in just a little more than 4 years of his Presidency, debt levels are now more than double the size as we approach $17 Trillion.

    Government-debtlevels-100813

    Maybe it’s just me but the shear “fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. government can’t pay its own bills.”  Maybe, just maybe, the Republicans are right in the opposing the effort to increase America’s debt limit

    Recession Risks Rise As Economic Confidence Collapses

    The side effect of the continuing barrage of media headlines about a potential debt default and economic calamity – is that it potentially becomes a self-fulfilling prophecy.  Recent Gallup Polls have showed a plunge in economic confidence by individuals which potentially puts the clamp on consumer spending and ultimately the economy.   From Gallup:

    “Americans’ confidence in the economy has deteriorated more in the past week during the partial government shutdown than in any week since Lehman Brothers collapsed on Sept. 15, 2008, which triggered a global economic crisis. Gallup’s Economic Confidence Index tumbled 12 points to -34 last week, the second-largest weekly decline since Gallup began tracking economic confidence daily in January 2008.”

    Gallup-economicconfidence-100813

    Fiscal brinksmanship in Washington is related to many of the largest weekly drops in Americans’ confidence in the economy since 2008. Gallup’s Economic Confidence Index fell nine points in late February and early March 2013 as Congress and President Barack Obama failed to reach an agreement to avoid automatic federal spending cuts as part of sequestration. Economic confidence fell eight points during the week ending Feb. 20, 2011, as Congress and the president reached an agreement on the federal budget at the last minute, avoiding a government shutdown.

    Americans’ confidence in the economy fell eight points during two separate weeks in July 2011, as leaders in Washington debated over whether to raise the debt limit or default on the nation’s debts. Standard & Poor’s subsequent downgrading of the U.S. credit rating and falling U.S. stock market prices also negatively affected Americans’ confidence in the economy. Similarly, economic confidence could continue to fall in the coming days and weeks as Congress and the president work to reach an agreement to raise the debt ceiling by the upcoming Oct. 17 deadline.

    Still, economic confidence bounced back within several months of the 2011 debt crisis and the downgrading of the U.S. credit rating. Likewise, confidence rebounded within weeks of the sequestration spending cuts that took effect in early March 2013. This suggests that these fiscal debates may not affect consumer confidence in the same long-term negative way that hits to the economy — like the 2008-2009 economic recessions — do.

    Gallup’s Economic Confidence Index has plunged 19 points since the middle of September and is now, at -34, at its lowest level since late December 2011. Confidence is significantly worse than it was in late May and early June of this year, when it peaked at -3.”

    Gallup-economicconfidence-100813-2

    I agree with Gallup’s assessment that political dysfunction has a tendency not to effect the economy longer term.  However, the difference between 2011 and today, with regards to the financial markets and the economy, is that the economic underpinnings of earnings and activity were trending positively at that time.  That is not so much the case today and the sharp decline in consumer confidence could have a greater impact on the economy than what we witnessed previously.  Given the ongoing deterioration in the trends of economic data the collapse in confidence certainly increases the risk of a recession short term.

    A quick resolution to the debt ceiling debate and government shut down will likely send the markets sharply higher and ease some of the stress on the economy.  However, the longer that the current stalemate ensues the more damage the economy will incur.  The next few days should prove to be very interesting to say the least.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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