Past Speeches, Future Ramifications

(Draghi and Bernanke)

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There’s been a lot of focus on Central Bankers, Mario Draghi and Ben Bernanke by the financial community as of late, and rightly so. Economics 101 discusses the role that monetary policy plays on the economy such that central banks take action to “manage” a nation’s liquidity. There’s no question that the Federal Reserve Bank has played a role in helping our economy and the stock market recover from the 2007-2009 recession. In the stock market, we can see it clear as day in the following chart from Doug Short’s chart on QE, interest rates, and the stock market:

spx returns 2007 to 2012

What we’ve got over the past few year is a financial crisis due to the bursting of the housing bubble. If there’s anything I’ve learned in my sixteen years in the business, it’s that it takes a crisis for voters and politicians to make a change. A crisis in Europe has formed and Europe will do something about. The issue is that the social experiment, called the EU, is a pseudo federal government with each of its members expected to run budget deficits within an allowable range. It lacked the teeth to regulate its members. Trying to instill change is a lot harder than a voter going to the polls and voting for prop ###.

As ECB President, Mario Draghi, mentioned yesterday,

The euro was launched as a “currency without a state” to preserve the sovereignty and diversity of member countries…but as recent events have shown, this institutional framework left the euro area insufficiently equipped to ensure sound economic policies and effectively manage crises.

Draghi suggested that Europe neither must discard its 60 years of integration nor become a federalized republic like the United States of Europe. Instead, “politicial union can, and shall, develop hand-in-hand with fiscal, economic, and financial union” by “calmly asking ourselves which are the minimum requirements to complete economic and monetary union.” By doing the bare minimum to attain economic union, they hope to provide the benefits of market integration while maintaining cultural independence. By the changes last October and this June, it is clear that Europe’s politicians are moving forward towards increasing economic and political integration.

Some will argue whether the EU will succeed or fail. One of the arguments made as to the fall of the EU is that the cultures don’t jive and they lack the political will to solve the crisis. Google “Europe lacks political will” and you will find 15.8 million hits. If you use quotes, the number is drastically smaller, but still relatively large at 4,860 with many heads of state from around the world making such claims.

The carrot at the end of the stick has been generously applied to help guide country budgets back within guidelines. The use of funds at low rates of interest in return for austerity measures have helped for a little while, but cutting budgets in tough economic times lead to lower growth and lower taxes – a postive feedback loop – which is akin to kicking an economy while it’s down. Continuing to kick a guy who’s on the floor due to a blow isn’t going to help him recover. He’s going to lose consciousness as the body can’t coup with the pain.

The monetary policy in Europe has stepped in as a temporary fix to give politicians time to create a system that will work. Applying generous amounts of monetary policy (liquidity/QE/low interest rates) is akin to offering an oxygen mask or pain suppressor to relieve the body’s nervous system of the painful stimuli. Removing monetary policy from the picture and placing all of the responsibility on government to cut spending is like doing surgery without anesthesiology. Not only is it unnecessary, it’s irresponsible and we have come to the collective opinion as a society that such activities are barbaric and unfathomable in this modern age of medicine. Why then do analysts, economists, and free lancing columnists believe that when a bubble collapses, there shouldn’t be any anesthetics?

The issue is that the economic body becomes dependent upon quantitative easing narcotics and politicians “bide their time.” We have been at a political stand still in our own country facing the same exact issues as Europe with bloated spending budgets and a burdening entitlement system that is only getting larger by the day. When it comes to this responsibility, we have nobody else to blame but ourselves. We vote the politicians in. The inability of our politicians to vote for a sound and economically viable plan to change our structural unemployment issues and the widening gap between funded and unfunded entitlements is directly correlated to the collective apathy of the American voter; however, times are a changing.

The fiscal cliff, the debt limit debate in 2011, and the emergence of the Tea Party and Occupy Wall Street are all signs that the American voter is beginning to wake up. I’m saying we must be careful between the many extreme opinions on the economy and government. Doing away with the Federal Reserve and monetary policy is akin to doing away with the anesthesiologist in the operation room. Let’s just make sure the patient doesn’t get addicted to the pain meds after the operation is done and our patient is recovering.

Eventually, when the economic patient is recovering and we begin the healing process, two things are important:

  1. Get the patient off pain meds as soon as possible to remove dependency and
  2. Primum non nocere – “first, do no harm” and let the body heal itself.

As the Fed’s Plosser said on CNBC today, he doesn’t see any point to growing the Fed’s balance sheet any further. If our economy is growing at 1.7% a year I have to agree. We don’t need more money printing while the economy is growing and we’re not in a financial crisis as we were in 2008. We shouldn’t be inflating our money supply to foster consumption to help Europe export more. It’s time for Europe to take care of its own problems. Any more money printing at this late stage in the recovery will just foster runaway inflation down the road. It is clear in the past year that the Fed sees this outcome as well and has held its balance sheet relatively steady through sterilization in Operation Twist and has continued to “placate” the financial press with Fed-speak. I mean, look what they’ve been able to do for the past six months since February.

Secondly, austerity measures and taxation while the economy is still recovering is harmful. We’ve seen this to be the case in Europe. The region lacks growth because they’ve been hell bent on cutting fat through austerity measures. Better to begin taxing and increasing interest rates gradually after the economy is in full recovery. Unemployment is still high and global financial and economic markets are still weak. Positioning the largest tax increase I’ve heard of to take effect next year while crisis still abound is irresponsible. Taxmageddon and Fiscal Cliff, whatever you want to call it, is one way to do harm right as the American patient is only just starting to get off its feet from the botched housing bubble operation. Voters, don’t let this happen!

The Market Days Ahead

Many analysts will have you believe that Bernanke’s speech tomorrow is important. I believe it is, but I don’t think our recovery hinges on it. I don’t think we’ll hear much more than “the Fed is prepared to do more” which is the same speech we’ve been hearing for six months. The only reason I think tomorrow is important is that expectations have dropped so low for the Fed, that if they did announce QE or negative rates of interest for banks, it would have a huge positive shock on the market. Rather, the market has been mainly moving on news surrounding Europe, and there will be a lot of it next week too.

  • Monday – The EU Finance Ministers meet to discuss Greece and Spain while our markets are closed. Also on Monday are the Manufacturing PMIs for Europe and China
  • Tuesday – U.S. Manufacturing numbers and our markets will be playing catch up to Europe news
  • Thursday – ECB meeting
  • Friday – Jobs report

Technically speaking, the recovery in the equity market will hinge on European fiscal and monetary policy next week. The equity markets have worked off their overbought condition in August by trading sideways. We closed today at short-term support for the S&P 500 near 1400 with intermediate support near the 50-day moving average and trend support near 1375 currently. I expect the market to be very volatile next week due to so many large catalysts that could result in different outcomes. But, I do think the outcome from next week will greatly dictate the direction of the market for the next few months, at least, until the market gets the jitters over the Fiscal Cliff. As the year-end and election time quickly approaches, market participants will be less concerned over Europe with their attention affixed back home.

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About Ryan Puplava CMT