Market Commentary

The $64,000 question is whether one fully believes the November labor data.
December 08, 2009

The $64,000 question is whether one fully believes the November labor data.  If so, the economic recovery is occurring more rapidly than virtually anyone has been expecting and removal of some of the all out monetary stimulus should come sooner than is being discounted.

Early yesterday morning the credit markets were suggesting the possibility of a change in monetary policy as early as January.  Wow!  If anyone had remotely penned this thought two weeks ago that person would be branded as somewhere between a lunatic and left field.

What are the odds inflation, not deflation, evolves into the biggest threat to the economy?  As written many times excess bank reserves are now in excess of $1 trillion versus the historical average of around $1-$2 billion.  Monetary velocity is somewhere between zero and immeasurable therefore any acceleration would be large.

As widely noted the federal deficit in the fiscal year ending 2009 is around $1.4 trillion or about 10% of GDP.  As per First Trust the interest cost servicing the national debt is 1.3% of GDP, considerably lower than the 3% level experienced in the 1980s and 1990s.

What would be the impact to deficit projections if the Federal Reserve falls behind the proverbial inflationary curve if monetary velocity suddenly accelerates? Again referencing First Trust, the average maturity of US government debt is 4.5 years. 

FRB Chairman Bernanke is a student of the Depression.  It is now widely known that one of the greatest errors made during that era was premature tightening that ushered in the second and more painful leg of the depression. 

It is against this backdrop, as well as from official statements perhaps supported by the events of yesteryear, is why consensus believes a change in interest rates might not occur until late 2010.

But what happens if inflation expectations become unanchored?  Would the mother of all interest rate increase occur? 

I think the Central Bank will closely monitor holiday sales and other real time data.  I do think the Federal Reserve will err on the side of inflation for this threat is easier to combat than deflation in an asset based economy however if the economy is accelerating a pace quicker than most expect a change in monetary policy could occur as early as March.

Speaking of the Central Bank, yesterday FRB Chair Bernanke spoke.  In my view he offered no new insight reiterating well versed comments that the economy is facing “formidable headwinds” that includes a weak labor market and tight credit likely to produce a “moderate” pace of expansion.  Bernanke further stated inflation remains “subdued” and might even move lower.

There are few comments I can make about yesterday’s market activity.  Both stocks and bonds were relatively unchanged.

Last night the foreign markets were down. London was down 1.47%, Paris down 1.64% and Frankfurt down 1.83%.  Japan was down 0.27% and Hang Sang down 1.18%.

The Dow should open moderately lower as the issues in Dubai are once again front and center fearing that this emerging city state is a possible canary in the coalmine. The 10-year is up 14/32 to yield 3.37%.