Thought of the Day

Sydney M. Williams

Thought of the Day

January 8, 2010

The Fed’s minutes for the December meeting were released on Wednesday. The interesting point from my perspective is that while the economic news continues to improve – real personal income continued at a “solid pace” in October, housing construction held “fairly steady” in recent months, real spending on equipment and software was estimated to have “risen slightly” and consumer spending appeared to be on a “moderately rising trend” – nevertheless the decision on rates was to keep the range at 0 to 0.25% for an “extended period.”

The Committee did indicate that “weakness in labor markets continues to be an important concern” and that they expected unemployment “to remain elevated for quite some time.” They also noted concerns “about the potential default by some sovereign borrowers.” But it has been positive news on economic growth that has been most surprising, to investors and probably to the Fed.

As a start to the unwinding of the stimulus, the Federal Reserve’s Open Market Committee indicated that they would gradually slow the pace of purchases of housing related agency debt and Mortgage Backed Securities. In the meantime, though, the Fed’s balance sheet will “expand significantly in the coming months.”

The size of the deficits is a concern to markets. The yield on Three-Month Treasuries has risen from five basis points in mid November to forty-five basis points today. In the same time the yield on the Five-Year has risen from 2.06% to 2.6% and the yield on the Ten-Year has gone from 3.2% to 3.8%. Government has four options for dealing with the deficit: they can raise taxes; they can allow the dollar to cheapen by inducing inflation; they can reduce spending, or they can encourage economic growth, thereby naturally increasing tax revenues.

Washington being Washington, reductions in spending will not happen. In fact, given current and expected legislation, spending will increase, perhaps at very high rates. The best way to encourage economic growth is through tax reductions, an unlikely event. That leaves, as the most likely path, the raising of taxes and/or inflating our way out of the problem. However, should growth in the economy persist, tax revenues will increase.

Nevertheless, the environment is not all bad for stocks. The market is a discounting mechanism. An article in Monday’s Wall Street Journal by Tom Lauricella pointed out that over the ten years ending December 31, 2009, stocks traded on the New York Stock Exchange lost an average of 0.32% a year – making it the worst calendar decade going back to the 1820s. Stock investors, despite last year’s rally, remain cautious. Between March and the end of December, Morningstar reported that investors pulled $20.7 billion from equity funds. During the same period they put $239 billion intro bond funds. Should rates rise and the economy continue to improve, we should see a reversal.