The Fed said its stimulus program is largely dependent on the health of the economy.
I have been in this business for over 25 years and can't recall a time when the state of financial markets was so data-dependent. But another factor in the Fed's decision not to rein in quantitative easing was the looming budget battles about to begin in Washington.
Indeed, Chairman Ben Bernanke diplomatically referred to the "upcoming fiscal debates" as a risk factor for the economy, which may have been enough to stay the Fed's hand. There is ample precedent for this.
Recall that leading up to the "fiscal cliff" in December 2012, the Fed expanded its third round of bond purchases to support the economy from fiscal follies.
Congress and the White House are already posturing for the latest budget brawl, but if history is any guide, the politically charged skirmish shouldn't last long, and any fallout will be short-lived. But markets are likely to remain volatile during this process.
Remember the turbulence last November and December created during the fiscal-cliff debate. And who can forget the debt-ceiling debacle of 2011 that resulted in a credit-rating downgrade and a 17 percent plunge in the S&P 500 over just a few weeks.
Beating the Market for Six Years Straight!
A small group of conservative stocks has been outperforming the broad S&P 500 for more than six years now. What's more, they've been spinning off massive piles of cash to shareholders the entire time.
It's a sad reminder of just how dysfunctional our political system has become that we are subjected to another ridiculous display of budget brinksmanship. Fortunately, the impact on financial markets is likely to be fleeting.
Forget the Sideshow
Rather than focusing on this political sideshow in the weeks ahead, it is best to keep a close eye on economic reports and especially third-quarter earnings.
The Fed last week singled out the "tightening of financial conditions" as a key reason to keep monetary policy ultra-easy for the time being. More specifically, policymakers are worried about the sudden increase in interest rates over the past few months.
Congress and the White House are posturing for the latest budget brawl. And markets are likely to remain volatile during this process.
Treasury bond yields have surged more than 100 basis points since May, putting a drag on an already fragile U.S. economy.
Ironically, a fiscal impasse a la 2011 could send yields lower as investors buy Treasury bonds as a safe haven. But for now, the Fed continues to "monitor economic and financial developments closely."
Since the Fed is so data-dependent, it makes sense for investors to watch two main categories: Employment and consumer spending.
It's clear that job growth is the key factor the Fed is watching to determine the course of monetary policy. Policymakers are on record saying the unemployment rate, currently at 7.3 percent, is unacceptably high, and they won't consider raising interest rates until joblessness falls below 6.5 percent.
But if job growth is the engine that ultimately drives economic expansion, then consumption is the transmission that can shift the economy into a higher gear.
Twin Engines of the Economy
Two factors typically support a robust economic expansion: Housing and income growth. And both have been subdued. Housing is often one of the first sectors of the economy to lead a recovery, but not this time, thanks to the aftermath of the real-estate bust and a massive overhang of unsold homes. (See the chart below.)
The housing sector may no longer be in critical condition, but it will take a long time to fully recover. That's why rapidly rising interest rates are such a threat. Since November 2012, the average interest rate for 30-year mortgage loans jumped 126 basis points (1.26 percent) to 4.6 percent. While still low by historic standards, the rise in home-financing costs could be pricing some homebuyers out of the market.
Mortgage-loan applications peaked in May, just as Fed Chairman Ben Bernanke started talking about tapering, or reducing the central bank's stimulus. Since then, refinancing applications have plunged 65 percent and purchase applications have slipped 13 percent.
Because the Fed's main tactic is to talk down interest rates to sustain the housing recovery, data on new- and existing-home sales, plus mortgage applications, which are a leading indicator of home sales, may be among the most important data to focus on these days. Mortgage applications slowed to 5.5 percent in the week ended Sept. 20 from 11.2 percent in the previous period. New-home sales rose 7.9 percent in August after plunging 13.4 percent in July.
Also of prime importance to the Fed and investors is consumer spending, which accounts for about 70 percent of gross domestic product. Personal-income growth and spending have been unusually weak this year. (See the chart below.)
Wages and salaries declined 0.3 percent in July, restraining consumer-spending growth to only 0.1 percent. Tomorrow we'll get August data on personal income and spending.
Third-quarter results will begin rolling in during the next several weeks, as Monday is the last day of the period. S&P 500 companies' profits are forecast to have grown 3.4 percent, slowing by almost half the rate in only three months, according to data from FactSet.
Eighty-eight of the 500 companies in the benchmark index have already lowered earnings estimates this quarter, with just 19 raising them. If that trend persists, investors will become more pessimistic.
The real test, as always, will be forward guidance, or companies' outlooks. At present, analysts expect 10.3 percent profit growth for the S&P 500 in the fourth quarter. That's twice the pace of the first three quarters of this year. What's more, revenue is expected to gain a paltry 2 percent.
Attention editors and publishers! Money and Markets teaser content may be republished with a link to the full story on MoneyandMarkets.com. Such republication must include attribution with a link to the MoneyandMarkets home page as follows: "Source: http://www.moneyandmarkets.com"
Money and Markets: A Division of Weiss Research, Inc. | 15430 Endeavour Dr. | Jupiter, FL 33478 | 1-800-291-8545