Right Said Fed

The November Advance Retail Sales came in better than expected as generous discounts and more optimistic consumers kicked off the holiday shopping season in a big way. Target and Macys were among the retailers reporting strong sales in November, largely due to impressive Thanksgiving sales.



One economist told Bloomberg News:



"Holiday sales are looking pretty good. Consumer spending will steadily improve in coming months. We're seeing a better overall economic outlook."



The street consensus if for improved consumer spending, but considering how poor consumer spending had been, even a big improvement could still leave consumer spending below to what we have become accustomed this far into a recovery. With unemployment expected to remain high and the housing market likely to remain impaired for several more years, consumer spending will likely rise slowly,



A sign that consumer spending is more than holiday driven is the report by Home Depot which indicated that sales of plumbing and electrical supplies rose. Although it is possible that many handy people are going to get what they want for Christmas, Home Depot's results look to be a sign that the pick up in consumer spending is more broadly based. On the down side, electronics retailer Best Buy reported worse-than-expected earnings as discounters such as Amazon and Wal-Mart are providing stiff competition





The headline PPI figure was up .8% versus a prior number of .4% (month-over-month) However, core PPI (MoM) came in at .4%, the smallest increase in five months. Much of the core PPI gain was due to higher energy prices (although egg prices were up a whopping 23%). How much will this influence CPI? Probably not that much. High unemployment, reduced household wealth and a fierce battle for market share are preventing businesses from passing price increases onto consumers. Raising prices is an almost sure way to lose market share in this environment. Instead businesses increase productivity by purchasing more efficient equipment or send jobs to lower-labor regions. This is helping to moderate the employment recovery.





The Fed will announce its rate decision this afternoon, there should be no surprises. The Fed will leave the Fed Funds target rate at between 0.00% and 0.25%. It is likely to reinforce its commitment to QE2, but its statement may very well have a more positive tone as to the strength and pace of the recovery.



The question which is being asked across the industry (across the country, actually), is: Is QE2 working. One could argue is that QE2 has sparked inflation fears in many areas of the economy, but has not helped to boost prices in the sector for which the Fed had hoped to see higher prices, real estate. However, some experts believe that Fed policies are working.



In today's Wall Street Journal, Wharton Professor Jeremy Siegel opines that QE2 is working and the sign that is working is higher treasury yields. Higher yields in among U.S. treasuries have been pointed to as a sign that Fed policy has been a failure based on the belief that QE2 has pushed bond yields and mortgage rates higher due to increased inflation fears because the Fed is causing the government to print money. This is the so-called vigilante theory.



Mr. Siegel argues that the real reason rate have been rising is that the bind market is becoming more optimistic that the economic recovery is strengthening, He states:



"Long-term Treasury rates are influenced positively by economic growth-which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity-and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields."



Mr. Siegel gets no argument from us, but bond yields are up for a variety of reasons. One reason is certainly due to better growth prospects. However, some of it is due to inflation fears due to the printing of money (we would argue that most of the vigilantism was in response to the tax cut extensions). Seemingly lost in this discussion is that fact that in the months leading up to the launch of QE2, many market participants purchased large amounts of U.S. treasuries on the beliefs that the size of QE2 would be much larger (some thought it would be nearly twice the size of what actually launched) and that the Fed would also target the very long end of the yield curve. Neither scenario played out.



There has been much talk about how the bull market in binds is over. No kidding, When the 10-year treasury note was around 2.50%, did any responsible person really believe it was going much lower (higher in price)? And if so, did any responsible person really believe it would stay there for a long period of time. Look at where long-term U.S. interest rates are, currently. If they rose 50 or even 100 basis points they would still be on the historically low side.

Just because the bull market is over does not mean that the bear market will push rates bank to what were common in the early 1980s. It does not even mean that they will rise to where they were in the early 1990s. All it means is that the probabilities for a double-dip recession of lessened and that the market has readjusted. Of course if one has laddered and diversified one's portfolio, one probably has little angst over where rates are going.