U.S. stocks bounced between gain and loss on several occasions on Friday, certainly norm these days, and for a second-straight session a late-day move pushed stocks mildly into positive territory.

Six of the 10 major industry groups rose for the day, led by energy shares.  Health-care stocks led the four groups that closed lower. 

For the week, the S&P 500 gained 2.37% (thanks to Tuesday’s 2.35% rally) and this completes the best back-to-back weekly gains since November.  Currently, the broad market is 8.20% below the 19-month high hit on April 23 – a decline that had been 13.70% prior to this two-week move.

Friday was a quiet day, except for the quarterly event that is quadruple witching – the expiration of stock-index and single-stock options and futures – and the volatility that volumes that results.  (Although, with daily volume soft for a long time and volatility higher than what is certainly normal, the effect quadruple witching has on trading doesn’t appear very unusual.

However, things became more interesting over the weekend with the Chinese announcing they’ll allow the yuan to float in a tight range and U.S. warships headed to the Red Sea.  We’ll touch on these events below.

Market Activity for June 18, 2010

Friday seemed to offer a respite from the European debt problem as concerns were quiescent after the latest Spanish government bond auction (Thursday) went well -- no problem funding their debt just yet, but of course the ECB is in their providing plenty of support with their quantitative easing (QE) campaign.  

In other news Friday, I was also struck, not surprised but struck by the level of chutzpah, by comments from Federal Reserve Board Vice Chairman Donald Kohn via a WSJ piece – more on this below for those who care to read it.  In short, the Fed remains completely unwilling to admit that their aggressive easing actions in the previous decade had anything to do with the housing bubble. 

Over the weekend though things got more interesting as China announced it would allow their currency, the yuan, to float in a tight range relative to the dollar.  Outside of some adjusting back 2005-2007, the Chinese yuan has been pegged to the dollar since 1994, if memory serves – this helped the Chinese escape the worst of the Asian Contagion, which was a currency story. 

I’ll note, the float the Chinese will manage is slight, allowing the yuan to trade just 0.5% from the stated exchange rate of 6.83 per U.S. dollar.  The news has stock-index futures all excited, following a big session from Asian stocks last night – up 1.5%-3.0% across the board.  Commodity prices also received a boost from the news.  If traders believe the Chinese yuan will be allowed to strengthen, then that makes commodities cheaper for them and hence will consume more.  Crude is making a run for $80/barrel again.

I think the move by the Chinese is more about getting in front of this coming weekend’s G-20 meeting in which yuan appreciation was going to be a big topic than any real desire to appreciate the currency.  

So, we’ll see if the Chinese allow meaningful appreciation, for me I’m completely indifferent.  Those expecting that yuan appreciation will bring low-paying manufacturing jobs back to the U.S. apparently are unaware that Vietnam is the next China on this front. 

If one wants to take a good and a bad from this announcement:  The good would be that this news may ease the protectionist bent in the U.S. Congress, although I’ll bet politicians will not be impressed by the narrow appreciation the Chinese are said to allow.  The bad is that if they really do allow a more substantial 2-5% per year yuan appreciation, then this means the Chinese don’t need to buy as many dollars, which means their purchases of U.S. government debt eases and interest rates rise if demand doesn’t show up from some other source.  (I’ll note again though, it’s my expectation that the Fed will be engaging in another round of QE, and this one will make the previous bond-purchase program pale in comparison, so demand, even if artificial, will likely be there.  Expect an announcement late 2010/early 2011).

The other weekend development was that 11 U.S. warships, including the USS Harry Truman, passed through the Suez Canal to enter the Red Sea.  It appears we’ve got aims of inspecting that Iranian flotilla that is headed for Gaza. 

Unwilling to Admit Any Fault

In a WSJ article on Friday, outgoing Federal Reserve Board Vice Chairman Donald Kohn stated the following: “Since the early 1980s we’d had a recession only about every 10 years or so.  That stability created the seeds of its own destruction.  People got far too used to economic stability; they thought they didn’t need to be as careful as they were before.  For example they thought house prices would go up forever, and recessions would be mild and infrequent.”

Upon reading the first part of this statement I was willing to agree to some degree.  That is, after an extraordinary run in stock prices from 1982-2000, households clearly become too complacent with regard to the cash saving they held ; certainly stocks are a huge savings vehicle these days and as wealth rose at a pace probably never seen before, then yes that can make people less “careful” as Kohn put it.  But it was his example that set me off.

So, we’re supposed to believe that economic stability is a bad thing?  That this stability caused people to invest, take cash out and buy houses as if they would never fall again.  It seems strange that Kohn would bring this up as an example for it was the Fed’s very loose monetary policy (pushing their fed funds rate down to 1% for a full year June 2003- June 2004 and holding the rate below the level of inflation for three full years – a negative real fed funds rate incentives people to increase debt) that was the origin of the housing bubble and damaging levels of institutional leverage.

The Fed’s policy mistakes caused the misallocation of resources within the housing market and to this day the Fed is completely unwilling to accept responsibility for this mess.  Yes, there were lax lending standards, rating agencies that clearly either had no clue or were beholden to the very issuers that pay them, social engineering from Congress to get as many people as possible into houses and personal choices that also played major roles.  However, without the very low rates that spark this event, none of those other things would have likely occurred or had much of a chance of causing serious havoc. (And virtually non-existent lending standards is a result of the housing boom, not the origin.)

And then Kohn moves on to stock prices.  He blames innovation for the high-tech boom and mispricing of assets.  It wasn’t the Fed easing campaign as they looked to head off that boogeyman that was the perceived Y2K problem, or the negative real interest rates of the previous decade.  No, the Fed is not to blame.  Now, they have been pushing people into riskier assets for over a year as they’ve made safe savings vehicles extremely unappealing.

The fact that the Fed remains recalcitrant, unwilling to accept any blame whatsoever, shows that they will continue to cause major havoc in the future.    

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900