"One is never afraid of the unknown; one is afraid of the known coming to an end."
So It Begins...
The FOMC goes into session today, beginning a two-day meeting that will culminate with Wednesday's policy announcement at 2 p.m. ET, and Chair Janet Yellen's press conference about a half hour later. This is probably the big one, gang, for us Fed watchers. This is expected to be the meeting where significant policy changes will ultimately decide how what has transpired over the last nine years or so goes down in the history books. How, these changes impact economies and markets will, in the end, be how the era's impact players end up being judged, and how tomorrow's central bankers are trained.
First let's look at the Fed Funds Rate. For home-gamers who may have been afraid to ask, or for the newbies, this is the rate targeted by the Federal Reserve Bank only for overnight borrowing by creditworthy institutions. This is considered to be perhaps, the most influential interest rate in the U.S. economy. This is also the rate that we, in the financial media, refer to when we broadly state that we expect the FOMC (Federal Open Market Committee) to raise or cut interest rates.
The Fed has historically preferred to make changes to this rate only at FOMC meetings that also come with an update to the Fed's economic forecasts, as well as at a press conference where the Chair is subjected to a sometimes-intense period of questioning by the media.
Futures trading at the CME in Chicago is pricing in a 57% likelihood right now of an increase in the target for Fed Funds Rate at the December meeting -- from the 1% to 1.25% range, where that rate now stands. There is no scheduled press conference set for the November meeting, and if the FOMC takes a pass in December, the next policy meeting paired with a press conference is scheduled for March. The bottom line here is that December brings with it some sense of urgency, given that tomorrow's announcement probably brings with it... far greater purpose.
Gary Cohn should be next Fed chair?
So, let's try to grasp this greater purpose. Most Fed watcher expect that at the conclusion of this policy meeting, the FOMC announces that it will take the first baby step in trying to manage downward the size of it's $4.2 trillion balance sheet. That balance sheet, for the uninitiated, is the Fed's portfolio of U.S. Treasuries and mortgage-backed securities that the central bank has acquired through three quantitative easing programs (those programs concluded in 2014), and through the reinvestment of the proceeds from maturing bonds. That reinvestment program has been a continued source of liquidity, as well as one giant reason why interest rates have remained so low, despite the termination of overt QE.
It is with a portfolio bearing an ownership stake of 17% of the entire Treasury market, and 29% of the entire market for mortgage bonds issued by government-related entities that we expect the Fed to try to, if not tackle... at least manage. This is the monster under your bed. To this point, the Fed has either been lucky or good -- maybe both. The economy is growing, perhaps slightly above trend. Unemployment is low. Consumer level inflation has not materialized in the manner that many experts, including this one, expected back in 2008.
Thanks to the aggressive quantitative easing programs run by other central banks, there has been no significant currency debasement. In other words, if you're going to get this show on the road, the road is currently presenting you with the opportunity to pass through. The trick will be to pass unmolested. How difficult will it be to whittle down the balance sheet to more comfortable levels without disrupting both the economy and the financial marketplace? Then, where are those end-game levels?
Trick or Treat
The FOMC will most likely start very small. Remember they bought the securities in their portfolio at very high prices that they themselves artificially orchestrated. Now, unless some unforeseen force comes out of nowhere with a tremendous appetite for debt securities, the central bank will allow the value of this portfolio to drop. Now, back to the size of that baby step. Several Fed speakers have telegraphed ahead of time, that the initial roll off of maturing bonds would amount to something like $10 billion (60/40 split between Treasuries/Mortgage bonds). If markets absorb this step well, and the economy does not openly revolt, this roll-off will incrementally be increased in size every quarter, with a cap of $50 billion per month having already been spoken of.
The balance sheet peaked ($4.5 trillion) at 5X it's pre-crisis size, which was $900 billion. The realistic goal for the central bank does not likely come close to reaching something that small. Most Fed watchers are hoping that the balance sheet can get down to somewhere between $2.5 trillion and $3.5 trillion before either the Fed feels comfortable with their book, or the economy forces the committee to reverse course.
With an abundance of luck, this program will run in the background, simultaneous with ongoing open market operations. Those at the FOMC, and those of us competing in this economy, would love to have this program run it's course without consequence. The success, or lack of success by the Fed to extricate themselves from crisis-level monetary policy with minimal impact will ultimately be how quantitative easing as a policy tool, and former Chair Ben Bernanke, are judged. These steps are also likely to be looked at as a road map for European and Japanese central bankers. There is clear and present danger on both sides of this coin.
In science, the same factors produce the same outcomes under the same conditions. They are considered fact. Fact can be guaranteed, because the conditions are believed controllable. There has been some debate for virtually all of my life (even longer) over whether or not Economics is a science or an art. I believe that Economics has to be an art form, because the first and most important factor in producing financial result is human response. Therefore, no policy outcome can ever be truly expected just because it worked that way before. People are by nature emotional. I would hope that our central bankers have learned this through the failure of their simplistic Phillips Curve. I doubt that.
Be Not Afraid
Remember, gang, something difficult is not automatically intimidating. There is only one way to move into the unknown. That is with your shoulder squared, your mouth shut, and your fists clenched. We will not run and hide. We will deal with price discovery at the point of sale. That is all the fact we need. We are still tough. We are still hungry.
Robert Frost wrote it best in 1923. I think it now pertinent. Adventure awaits.
The woods are lovely, dark and deep,
But I have promises to keep,
And miles to go before I sleep,
And miles to go before I sleep.
- WTI Crude settled at $49.91, which was a seven-week high on Monday. The entire energy sector watches with bated breath as the commodity again tries to find support at, or above, $50 this morning.
- Fertilizer stocks went wild on Monday. The reason? I see nothing, but where there is smoke there is usually fire. CF Industries (CF - Get Report) , Mosaic (MOS - Get Report) , Potash (POT) , and Agrium (AGU) all soared by multiple percentage points on the day.
- The U.S. Senate passed the National Defense Authorization Act for fiscal year 2018. This bill would take defense spending up to $700 billion from 2017's $619 billion. This bill must now be reconciled with a similar version of the bill already passed by the House in June. Then Congress will consider a final version, which will likely be hotly debated as the money is drawn from other sources.
Toys 'R' Us just filed for bankruptcy protection.
08:30 - Housing Starts (August): Expecting 1.778M, July 1.155M SAAR.
08:30 - Building Permits (August): Expecting 1.22M, July 1.223M SAAR. Housing Starts missed expectations in July. That did not foretell the end of the trend for this series, which has been largely sideways for more than two years. What is noticeably negative is that the miss was the fourth for the series in a five-month span. Not lost on this economy watcher has been the slight tapering in home-builder optimism is recent months. Still quite confident, but obvious frustration with the trajectory of the business. This will be your macro event of the day.
08:30 - Import Prices (August): Expecting 0.4%, July 0.1% m/m.
08:30 - Export Prices (August): Expecting 0.4%, July 0.4% m/m. A month of soaring agricultural export prices was enough to drag export prices in general into decisively positive territory in July. For August, we expect that energy prices will turn the same trick for import prices, while exports repeat their trick. This series is a relevant measure of inflation, but really not so much a measure of cross-border demand. This item will impact the marketplace less so than will the Housing Starts data.
08:55 - Redbook (Weekly): Last Week 4.5% y/y. While everyone talks about the struggles of the retail sector, this series, which is a measure of chain store sales at the retail level, has been getting hot. Super hot. In terms of year-over-year growth, the last three weeks have been the three strongest weeks seen for this series since 2015. Keep your eyes on this one.
Sarge's Trading Levels
These are my levels to watch today for where I think that the S&P 500, and the Russell 2000 might either pause or turn.
SPX: 2524, 2513, 2506, 2499, 2492, 2482
RUT: 1458, 1451, 1444, 1436, 1428, 1422
Today's Earnings Highlights (Consensus EPS Expectations)
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