Fed Extends Operation Twist – Europe at the Brink

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
June 26, 2012

IN THIS ISSUE:

1. Operation Twist Extended Until Year-end

2. Fed Revises Economic Forecasts Lower

3. The End of the Road for Europe?

4. Foreign Holdings of US Debt Hit Record High

5. Supreme Court Defers ObamaCare Decision to Thursday

Operation Twist Extended Until Year-end

For the last several months I have argued that the most likely time for the Fed to enact another round of stimulus would be at the June 19-20 FOMC meeting. I first suggested this in my March 13 E-Letter. My main reasoning was that Bernanke would not want to do it after June 19-20 for fear that it would be seen as a political move ahead of the November elections.

As I’m sure you know by now, the Fed elected to extend “Operation Twist” last Wednesday, June 20. Operation Twist is the action whereby the Fed uses cash from the sale or maturity of short-dated Treasuries to buy longer-dated securities, in an effort to bring down long-term rates. The Fed says it will make $267 billion in such purchases and the Twist will continue until the end of this year.

The stock markets were clearly expecting more than an extension of the Twist. The consensus was that Bernanke would announce QE3. That didn’t happen, so the markets sold off like crazy on Thursday with the Dow plunging almost 2% that day and have continued lower since then.

In Bernanke’s press conference following the FOMC meeting, he was asked repeatedly if the Fed could do more to stimulate the economy. Big Ben said there is indeed more that the Fed can do, including QE3, but he said the Fed wants to see more data on the economy before it would take that step.

While he didn’t say so specifically, it looks like the Fed wants to see the advance estimate of 2Q GDP near the end of July. Of course they will be watching all of the economic reports between now and the next FOMC meeting on July 31/August 1. If the data continue to show a weakening economy, it raises the odds that the Fed could announce QE3 on August 1.

There was an interesting change in the FOMC’s official policy “statement” released last Wednesday. For months now, the statement included the following key sentence:

“The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.”

That sentence was changed to read as follows at last Wednesday’s FOMC meeting:

“The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” [Emphasis added.]

The change from regularly review and adjust as appropriate to prepared to take further action was seen by many Fed watchers as a big deal. It certainly paves the way for some kind of action on August 1. But keep in mind that Bernanke made it clear that QE3 is not an option unless the economic data between now and the end of July are mostly negative. We’ll see.

In his press conference last Wednesday, Bernanke also made it clear that the Fed does not want to enact QE3. He stated several times that there are “risks” associated with pumping more money into the system. I think the mainstream media may have understood that, finally.

The fact that the Fed didn’t announce QE3 last week has made some in the mainstream media begin to at least ponder the possibility that the Fed is not going to resort to QE3 unless the economy really tanks (ie – recession), or if the European debt dilemma turns into a full-blown monetary crisis.

Washington Post columnist Ezra Kline summed up this realization last week:

“If there’s more Bernanke could be doing, and if what he’s doing could be effective, then it seems downright cruel to be holding out on a labor market with 8.2 percent unemployment. If the policies he could pull out, however, are so risky and ineffective that even 8.2 percent isn’t reason enough to use them, then is there really anything more the Fed can do?

To put it another way, a scary interpretation of Bernanke’s position is that he doesn’t believe the Fed could do much more to help the economy, but he doesn’t want the market to know that, and so he keeps not doing more but telling the markets he could do more if he wanted to. As one wag put it on Twitter, the bazooka Bernanke says he’s got in his pocket is really just his finger.”

A more benign interpretation is that he doesn’t have internal support for doing more, or that he’s only got a few bullets left in the gun and he wants to make sure they’re still there if Europe really deteriorates and he suddenly has to combat another crisis.”

The mainstream media desperately wants the Fed to do QE3 as soon as possible in the hopes that the economy will be in better shape before the election, which would be beneficial for President Obama. But the Fed’s latest action to extend Operation Twist through the end of this year probably means that we don’t get QE3 this year, unless something really negative occurs.

There are people who disagree and believe that the change in the policy statement means that the Fed is ready to pull the trigger on QE3 on August 1. I have attached one such opinion piece from Bill McBride of “Calculated RISK” in Special Articles below (I have not heard of Mr. McBride or the company he writes for before this week).

Whatever happens, let me remind everyone that since QE1 (Nov. 2008) and QE2 (Nov. 2010), the Fed has purchased $2.9 trillion in securities, some of which are of questionable value. But the real question is, how much has that helped our economy? GDP was +1.7% in 2011 and only +1.9% in the 1Q of this year. I would say that QE hasn’t helped very much. No wonder the Fed is hesitant to do more, knowing they will have to unload these same securities someday.

Fed Revises Economic Forecasts Lower

In addition to extending the Twist through year-end, the Fed also revised its forecasts for the economy at the latest FOMC meeting. At the April meeting, the Fed forecasted that the US economy would grow by 2.4%-2.9% in 2012. Last week, however, the Fed revised those numbers down to GDP growth of only 1.9%-2.4% this year.

As for 2013, the Fed also reduced its GDP forecast. Officials estimated the nation’s economy would grow from 2.2% to 2.8% next year, down from its April projection of 2.7% to 3.1%. While these GDP revisions were disappointing, at least the Fed is not looking for a recession.

The Fed’s forecasts for unemployment were similarly disappointing. They now expect the US unemployment rate to be 8.0%-8.2% for all of this year and 7.8%-8.0% for 2013. Just a few months ago there was some hope that the unemployment rate might dip to near 7% by late this year, but that optimism has faded now.

The FOMC noted that while it expected growth would continue at a “moderate pace,” job creation and household spending both slowed in recent months. Mr. Bernanke said the housing depression, domestic fiscal policy and Europe’s downturn were dragging on growth.

The End of the Road for Europe?

After kicking the financial can down the road for the last two years, it seems increasingly likely that Europe is approaching the end of the road. A critical summit in Brussels will happen on Thursday and Friday of this week, and fear is increasing that without some kind of break-through plan, we could see the breakup of the Eurozone very soon.

Greece has formed a new coalition government and word is that its representatives will go to the summit to ask for a two-year extension of the deadline to meet its already agreed-upon austerity program. Germany has already telegraphed that its answer will be NO. A recent poll showed that over 75% of Germans want Greece to leave the European Union, along with a majority of people in France and Spain.

The leaders of Germany, France, Italy and Spain met in Rome last week and reportedly came away with a new stimulus plan totaling around $160 billion. That would be a relative drop in the bucket for stemming the recession/financial crisis in southern Europe. Spain is expected to receive an emergency loan of $125 billion any day now to shore up its banks. But we’re also hearing that Spain will need much more than that to stay afloat.

Making matters even worse, Moody’s cut its credit ratings for 28 Spanish banks Monday night. Rumors of the downgrades slammed Spanish stocks yesterday, which affected stock prices all across Europe and even here in the US.

The Euro

So the news from Europe is unrelentingly bad and it's hard to see how the Eurozone will be able to successfully resolve this crisis. Real fixes are years away and would require that individual nations give up some degree of sovereignty and financial control of their individual destinies.

There are reports out this morning that finance ministers for Germany, France, Italy and Spain, meeting ahead of the Thursday/Friday summit, are talking about some kind of “joint banking union” across the region. Details are fuzzy at this point, but such a union would supposedly include the powers to liquidate insolvent banks, set up a deposit guarantee fund (FDIC-like) and expand the European Central Bank significantly.

The problem is, any such banking union would not occur, if at all, until sometime in 2013. I’m just speculating here, but I would bet that this new banking union idea is just another veiled attempt at creating Eurobonds, and Germany will have none of that.

Many now fear that if this week’s summit doesn’t produce a “grand plan,” the European Union could begin to break apart very soon. The only thing resembling a grand plan at this point is the introduction of so-called “Eurobonds” that would be jointly issued and backed by the 17 Eurozone nations. But as noted above, Germany has flatly said “nein” to that idea every time it has been brought up.

Things are so bad at this point, I am reading stories which say that several European nations (especially France and Germany) are now considering authorizing border controls, which were abolished when the euro was established in 1995. These border control discussions are supposedly aimed at controlling immigration, but the real reason behind this may be stopping citizens from fleeing their home countries with their money should a financial crisis and economic chaos erupt.

Bottom Line: If the European Union dissolves, the result across Europe will most likely be a depression, double-digit unemployment, bank runs, currency devaluations and economic chaos. That almost certainly means a global recession, if not something even worse.

Foreign Holdings of US Debt Hit Record High

Editor’s Note: The following appeared on my Blog last Friday and is important enough to include in today’s E-Letter which has a much larger following. This is another reason why you should subscribe to my free Blog today.

The Treasury Department announced on June 15 that foreign demand for US Treasury securities rose to a record high in April. The Treasury reported that total foreign holdings of US debt rose 0.4% to $5.16 trillion. It was the fourth consecutive monthly increase.

Demand for US Treasury debt is rising largely because investors are worried about Europe's worsening financial crisis. Obviously, some of this increase in foreign demand is coming as a result of bank runs in Greece and Spain.

US government debt is considered one of the safest investments in the world, despite the fact that we are running trillion-dollar deficits and our national debt is over $15 trillion. As I noted in my June 7 E-Letter, it helps to be the best looking horse in the glue factory.

China, the largest buyer of Treasury debt, increased its holdings slightly after trimming them for two straight months. China boosted its holdings by 0.1% to a total of $1.15 trillion in April. That followed a 1% drop in March and a 0.9% decline in February.

Japan, the second-largest buyer of Treasury debt, trimmed its holdings 0.9% to $1.07 trillion. Brazil, the third-largest individual buyer of Treasury debt, boosted its holdings 5.3% to $246.7 billion.

Britain increased its holdings 26.5% to $154.2 billion while France increased its holdings by 29.4% to $59.4 billion. Germany, the largest economy in Europe, boosted its holdings of Treasury securities 1.5% to $65.6 billion.

Here are the 12 largest foreign holders of US government debt (per Treasury Dept. data):

China	1.15 trillion	United Kingdom	154.2 billion
Japan	1.07 trillion	Switzerland	151.1 billion
Oil Exporters (3)	252.4 billion	Russia	146.8 billion
Carib. Banks (4)	247.0 billion	Belgium	141.0 billion
Brazil	246.7 billion	Hong Kong	139.4 billion
Taiwan	188.3 billion	Luxembourg	125.0 billion

Demand for Treasury securities has remained strong despite the first-ever downgrade of the government's debt rating last August. Standard & Poor's lowered its rating on long-term Treasury debt one notch from AAA to AA+ following a prolonged debate in Congress over increasing the nation’s debt ceiling.

Earlier this month, S&P reaffirmed that rating and said it was keeping a “negative outlook” on the rating for the future. S&P warned that US political leaders were not addressing the federal debt burden. The rating agency predicted that the government’s debt held by the public , as a percent of the economy, would rise from 77% of GDP in 2011 to 83% this year and 87% by 2013.

These figures are misleading in that they don’t take into account Treasury securities of over $5 trillion owned by various government agencies. If we count that debt, the national debt is over 100% of GDP! The US national debt just topped $15.8 trillion, whereas annualized GDP was estimated at $15.4 trillion at the end of the 1Q.

The takeaway from the latest Treasury report is that there is still an appetite for US debt among foreign nations and their investors – at least for now. Unfortunately, the ability to borrow globally at very low interest rates allows politicians to keep spending like there’s no tomorrow.

Supreme Court Defers ObamaCare Decision to Thursday

The Supreme Court was widely expected to render its decision on ObamaCare on Monday morning. However, Chief Justice John Roberts announced early yesterday that the decision on ObamaCare would be deferred until Thursday. The reasons for the switch are not entirely clear, but Thursday is the last day for the announcement of the latest Supreme Court decisions.

The Court’s decision on ObamaCare is clearly the most important of all those to be announced this week, followed by the Arizona illegal immigration law decision which was announced yesterday. The High Court struck down several parts of that controversial law, but also left in place parts of it. As a result, politicos on both sides claimed victory.

As for ObamaCare, the consensus remains that the Supreme Court will strike down at least part of the unpopular law, most likely the individual mandate to buy health insurance or pay a penalty. Others believe the High Court will rule that the entire law is unconstitutional. But the reality is, no one knows what the decision will be. No leaks so far that we know of.

There is rampant speculation as to what will happen, whichever way the decision comes down. The mainstream media has done its part in recent weeks to emphasize how bad it will be if the healthcare law is struck down, but we are told that the Justices voted on this decision shortly after the oral arguments back in March.

The media also emphasized what a blow it would be to President Obama if his signature piece of legislation is struck down. Others argue quietly that it will help Obama’s chances in November if the law is struck down. A few have gone so far as to speculate that Obama will be relieved if the law is struck down.

President Obama has promised, if re-elected, that he will push for a new healthcare law as early as next year. Normally, I would doubt that given how much political capital he vaporized to get ObamaCare passed by a thread. But given his arrogance, it wouldn’t surprise me if he goes at it again if re-elected. If he does, expect him to go full-bore for a “single-payer” system.

In any case, if ObamaCare is struck down, expect to hear a chorus from the left bashing the Supreme Court shamelessly. The ObamaCare decision will very likely be another “5-4” ruling. If it is 5-4 to strike it down, the left will go ballistic! I could well see someone on the left exclaim: Four rich white guys and one misguided black guy just took away your health care, while they still have theirs. It will get very ugly!

Finally, I have suggested in recent weeks that if ObamaCare is struck down, in part or in full, that it will be bullish for the stock markets. While I still believe we’ll see a rally if it is struck down, it is obvious that the crisis in Europe is the biggest driver in the markets for now. That emphasizes why you need professional active-management strategies in your portfolio.

Wishing you a summer of fun,

Gary D. Halbert

SPECIAL ARTICLES

Bernanke Paves the Way for QE3 on August 1
http://www.calculatedriskblog.com/2012/06/bernanke-paves-way-for-qe3-on-august.html

Supreme Court ObamaCare Decision on Thursday
http://www.foxnews.com/politics/2012/06/25/supreme-court-expected-to-roll-out-obamacare-ruling-thursday/

Weekly economic commentary
http://www.realclearmarkets.com/blog/WeeklyEconomicFinancialCommentary_06222012%5B1%5D.pdf