Footy and the US Federal Reserve

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Please indulge your NSW born editor for a brief moment to savour the aroma of victory. Last night’s origin match was an ugly game but a beautiful win. Eight years of frustration and heartache…and yelling abuse at Justin Hodges for being a class A clown…all worth it. Ahhhh…

And the Socceroos were brilliant too. I watched the last 30 minutes after my daughter woke up needing a dummy adjustment. To use an old cliché, this World Cup tournament was so close, yet so far. But it shows Australia is growing on the world stage…and the future looks good. Bring on the Asian Cup (and another striker wouldn’t hurt, either).

Speaking of sports, the US Federal Reserve is playing a fine game of ‘maintain the confidence’. After concluding a two day meeting, the Fed revealed it will continue to reduce its tapering program by another US$10 billion per month (starting in July), saying the economy continues to improve. At the same time, it sharply downgraded its economic growth forecasts for the year.

And in case there was any confusion, the US Federal Reserve made it abundantly clear that after the taper, interest rates will stay low for a loooong time. Interest rate normalisation (raising rates) is still at the theoretical stage and the Fed will update us mortals on their thinking in future months.

Basically, the Fed isn’t doing anything on interest rates until inflation picks up above the 2% level or until the economy reaches ‘maximum’ employment. But the closely watched personal consumption expenditure (PCE) inflation measure is out this week and is likely to show that inflation is indeed running ABOVE the Fed’s 2% level.

What does Fed boss Yellen think about that? Well, she’s pretty much going to ignore it. In her opinion this increase in inflation is transitory. The markets love this stuff. Set targets and ignore them at your whim. Err on the side of caution…keep the liquidity spigot open as long as you can…fill up everyone’s cup.

Unsurprisingly, the S&P 500 rallied to new highs following the Fed’s statement and Yellen’s soothing Q&A session. The Fed is playing a very strong confidence game, and playing it well. They have the markets in the palm of their hand. After looking very shaky back in 2011, global central banks shocked the world into submission with a monetary blitz throughout the latter part of 2012.

That it has enriched a small minority is beside the point. It created belief and confidence, which is all that matters when it comes to markets and economics built on easy credit.

The new narrative in the market — growing in popularity by the day — is that the Fed can keep markets propped up for years to come. Our mate Kris Sayce was onto this narrative before anyone else, and his readers have done very well out of it. He’s still bullish and sees no reason to change his stance.

It’s a hard viewpoint to argue against…but I’ll give it a go anyway.

While I understand the view of Fed omnipotence and asset markets continuing stronger for longer, I also see different risks unfolding.

Each month, I look at the Treasury International Capital (TIC) data, which shows foreign capital flows into the US. It’s an important data release because the US runs a persistent current account deficit, meaning it consumes more than it produces. It’s been this way since the early 1970s.

Some form of external financing must account for the US’ excess consumption. Traditionally, foreigners have fulfilled this role, buying mainly US Treasuries in exchange for sending cash the US’ way. But by the end of 2013, foreigners no longer bought long term US assets such as Treasury bonds. In fact, they were selling them. During calendar year 2013, foreigners dumped US$350 billion worth of long term securities.

In the year to April 2014, they’ve sold US$190 billion worth of long term assets. Thankfully the Fed (the other source of ‘external’ deficit financing) stepped in and bought what foreign investors sold. The market doesn’t really care about this bizarre circumstance because the Fed is winning the con game, but for the past year or so, the US central bank has effectively financed the US current account deficit.

But now the US Federal Reserve is winding down its debt financing program. From 1 July, it will purchase $35 billion per month, or around $420 billion per annum. After they taper again at the next meeting, the annual rate of purchases will slow to $300 billion.

To maintain their current standard of living and feed the military industrial complex, the US currently needs around US$400 billion per annum from external sources — either foreign investors or their central bank.

After the Fed’s next taper in late July, it will no longer finance all of the US’ deficit. And as the taper continues in the following months, we’ll be back to relying on foreigners to fund 100% of the US’ excess consumption.

Now that should be a worrying thought if you’re in the ‘Fed can maintain this charade for years’ camp. Foreigners ARE still sending capital to the US, but they’re parking it in very short term vehicles…not long term assets like bonds.

The latest TIC data shows that, while foreign investors dumped US$190 billion in long term assets in the year to April, they INCREASED their US dollar cash holdings by over US$500 billion, for a net inflow of US$240 billion.

In effect, the US is financing its current account deficit by a combination of central bank monetisation and foreigners parking in cash. That’s risky, but it’s a risk the market doesn’t care about right now.

Ironically enough, it’s the work of the military industrial complex that could undermine today’s languid market conditions. The US’ military adventures in the Middle East and recently in Ukraine are causing a host of problems.

It’s leading to closer ties between China and Russia, who have a long term goal to get out from under the weight of the dollar-based global trading system. That’s easier said than done, and it won’t happen overnight.

But perhaps the process has been underway for a few years already, signified by the drop off in long term treasury purchases?

Whatever the case, it’s going to get interesting later in the year when the Fed stops funding the deficit. Will foreigners keep feeding the beast or will asset prices adjust lower to attract the funding?

It’s something I’ll be watching closely as the market snoozes through another Northern summer. Until then, keep punting if you’re so inclined. Or if you’re like me, worry.

I was going to let you know how the Reserve Bank of Australia responded to my questions (which you saw in yesterday’sDaily Reckoning) but I got caught up with footy and the Fed today. Keep your eye out for that tomorrow though. You’ll like it.

Regards,

Greg Canavan
for The Daily Reckoning Australia

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