Economy’s Recovering, But Fed Moves Anyway

The U.S. economy is recovering slowly but surely, and third-quarter corporate earnings growth verges on the spectacular. Of the 404 S&P 500 companies reporting so far, sales are up an average 7.3% from last year, while average annual earnings are up 44.8%! Due to positive economic fundamentals and a big shift in Congress, the Dow Industrials are now at a two-year high and President Obama has said that he will work with the new Congress on extending tax breaks into 2011, giving us yet another market catalyst. All of this good news makes me wonder why the Federal Reserve insists on launching a new round of easing! In the meantime, after a superb third quarter, I feel that a select group of large-cap stocks well poised to take full advantage of what is historically one of the strongest time periods for the stock market Massive Easing via QE-2 May be Unnecessary Last Wednesday, all eyes were glued on the Fed when it announced even more quantitative easing than most analysts had anticipated. The Fed’s Federal Open Market Committee (FOMC) announced that it is planning to buy $110 billion per month of long-term Treasury bonds ($75 billion of new bonds plus $35 billion of maturing mortgage bonds) each month for the next eight months, for an $880 billion buying spree that will persist through at least the middle of 2011. The FOMC is doing this, they say, because the U.S. economy is “slow,” employers remain reluctant to hire and inflation is “somewhat low.” (I should add that Kansas City Fed President Thomas Hoenig voted against the FOMC’s easy money policies.) The rest of the world is shaking its head at the FOMC’s liberal monetary policy. The next day, the Bank of England and the European Central Bank (ECB) announced that they would continue their austerity programs, foregoing any quantitative easing. The predictable outcome was that U.S. Treasury note and bond yields fell significantly, as the U.S. dollar reached new two-year lows to the British pound and euro. The dollar is also falling to most other major currencies, due largely to the rising rates of return in those other currencies. On Tuesday, the central banks of Australia and India raised their key interest rates by 0.25%, to 4.75% and 6.25% respectively, so these competing currencies remain very strong. Overall, the Fed has diverged from other central banks, undermining the U.S. dollar and boosting stock prices, since a weak U.S. dollar tends to boost the profits for commodity-related companies and multi-national concerns. The international criticism of the Fed’s QE-2 decision was relentless last week. On Thursday, CNBC reported that Germany’s Economic Minister Rainer Bruederle said that he was concerned about U.S. efforts to stimulate growth by injecting liquidity into the economy. Then, on Friday, Germany’s Finance Minister Wolfgang Schaeuble said the U.S. is undermining efforts to create a level playing field in the currency market, saying, “What the U.S. accuses China of doing, the U.S. is doing by different means.” In addition to Germany’s criticisms, Brazil warned that the latest round of “currency wars” could lead to retaliatory measures. Specifically, Brazil’s Finance Minister Guido Mantega said on Thursday that “it’s no use throwing dollars out of a helicopter,” adding that “the only result is to devalue the dollar to achieve greater competitiveness on international markets.” Also, Brazil’s outgoing President Lula da Silva said that Brazil’s leaders would “fight for Brazil’s interests” at the coming G20 summit in Seoul, South Korea by taking “all the necessary measures to not allow our currency to become overvalued.” Since early 2009, the Brazilian real is up 39% to the dollar, prompting fears that Brazil’s exports are now less competitive. Are the Fed and the Treasury Destroying the Dollar? This week, the G20 summit in Seoul, South Korea, will likely dominate the news, especially after Brazil, China and Germany criticized the Fed’s decision last week to launch another round of quantitative easing, which, combined with their ongoing zero-interest-rate policy, will insure a persistently weak U.S. dollar. It will be interesting to see if 18 of the G20 countries gang up on the U.S. and China this week, citing their continuing “currency manipulation.” Meanwhile, China is trying to distance itself from the Fed’s easy-money policies. Last Friday, China’s deputy foreign minister Cui Tiankai said that the U.S. plan for limiting current account surpluses and deficits to 4% of GDP harked back to the days of “planned economies.” Cui also said that the U.S. “owes us some explanation” for the Fed’s latest QE-2 plans. Many of the G20 leaders are also upset that the Fed’s quantitative easing move will risk a sharp rise in the U.S. budget deficit – something the G20 leaders want to prevent. At the last G20 summit in Toronto in June, the developed economies pledged to cut their deficits in half by 2013. In the meantime, CNBC reported last week that PIMCO’s Bill Gross said that the U.S. dollar is in danger of losing 20% of its value if the Fed continues current policies. Gross also said that “QE2 not only produces more dollars but it also lowers the yield that investors earn on them and makes foreigners less willing to hold dollars.” The good news is that a weak dollar is good for the stock market. The dollar hit a new two-year low at the same time stocks hit a two-year high, so the correlation between rising stocks and a falling dollar is clear.
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