It's Been a Long Time

It has been a while since I posted commentary. Let's discuss recent events.

Retail sales rose for the ninth consecutive month, albeit at a slower pace, as consumers continue to spend in the face of higher food and energy prices. The increase of retail sales indicates that prices might not havee risen high enough to snuff out consumer spending, but may have risen high enough to slow it down. This could be an example of the economic headwinds which he have discusses previously. The economic headwinds may not be stiff enough to stop the U.S. recovery, but could be enough to slow it down.



It should also be mentioned that a recent pick up in hiring is probably helping consumers to keep pace with higher food and energy costs, but consumers are also being helped by the one-year suspension of payroll taxes. Temporary tax cuts usually carry temporary benefits for consumption. The benefits tend to wane months before the temporary tax cuts end. It is not inconceivable that the benefits of the temporary tax cuts begin to provide diminishing returns with regard to consumer spending in the coming months.





Many economists were encouraged by the increased consumer spending across a broad spectrum of the economy. However, retailers such as Wal-Mart are concerned that higher commodities prices will continue to squeeze consumers. Yesterday Rosalind Brewer, the president of Wal-Mart’s “Wal-Mart East” division said the following during an investor presentation:



“We still see our customer financially strapped. We see the shopper’s wallet being stretched a lot more.”



Wal-Mart’s experiences are worth watching as many of its customers are of the lower-income and middle-income variety. Higher food and energy prices tend to act like a regressive tax on consumption. This means that lower-income consumers are usually impacted the hardest. It is encouraging see that consumer spending continues to increase, but the deceleration is concerning. As physics teaches us, deceleration is actually acceleration in the other direction.



Worries about higher food and energy prices squeezing consumers are beginning to appear among market participants. An article in today’s Wall Street Journal discusses the recent drop in commodities prices and how concerns about a squeezed consumer and slower economic growth could be behind the decline.



Yesterday’s decline in stocks, oil and basic goods has raised concerns that commodities prices have become too expensive for consumers who continue to deal with high unemployment and stagnant wages. Government data released yesterday reported a decline of U.S. exports in February, the first decline since August 2010. Many industry economists continue to lower growth estimates for 2011.



One market participant told Bloomberg News:







"The potential for a slowdown in the global growth story has finally come to fruition. I'm not saying we're going to get a recession, but if you look at the range of growth estimates for the year, people are coming in more toward the bottom of the range. It looks like expectations are on the muted side."

Many pundits and most consumers point to soaring gasoline prices as evidence of inflation. To anyone who must drive to work or to shuttle one’s family from place to place, higher fuel prices are inflationary. However, to the bond market and to many Fed officials inflation is not yet a problem.



We would caution investors against making fixed investment decisions based whether they or some pundit believes the Fed is wrong. It matters not what they believe the Fed should do about higher food and energy prices. It does not matter what we believe the Fed should do about higher food and energy prices. It only matters what the FOMC (specifically Ben Bernanke) believes the Fed should do about higher food and energy prices (or prices and growth as a whole for that matter). Bet against the Fed at your own risk.



Thus far the Fed has given us hints of what it may do going forward. It is probable that the Fed continues QE2 through June as planned, but then ceases bond purchases for the purpose of quantitative easing. That in itself could be considered policy tightening because it potentially removes price support (yield suppression) for the bond market. Higher yields in the open markets could curb inflation (and growth).



However, the cessation of QE2 may not have the effect on interest rates that most people expect. We would like to bring you back to last year when the Fed halted bond purchases as it let QE1 wind down. Following the cessation of QE1 (and other government stimulus measures), the yield of the 10-year treasury note fell.

Why did the yield of the 10-year U.S. treasury note fall when the Fed ended QE1 purchases and rise when the Fed announced it would purchase bonds to keep real interest rates at accommodative levels? The markets viewed the cessation of QE1 as disinflationary (the soft patch into which the U.S. economy fell was largely blamed on the removal of government stimulus). The markets viewed the possibility followed by the implementation of QE2 as being potentially inflationary.


When one stops to think, these were logical reactions. Why else would the Fed engage in quantitative easing except to stimulate consumption and economic growth which are usually inflationary in their effect? The drop in rates following the cessation of QE1 likely reflected market sentiment that a double-dip recession was possible. The response to QE2 was a kind of relief price selloff / yield rally. So what do fixed income market participants believe is coming down the pike? For that we turn to the Bloomberg survey