After Federal Reserve Chairman Ben S. Bernanke said that The Fed may cut the pace of its bond purchases, first U.S. Treasuries slid, then Japan’s bond market fell.  When Japanese markets opened, the bond futures market was halted on a circuit breaker as the bond market took a swan dive.  U.S. 10-year rates climbed to 2.07 percent, their highest level since March, while 10-year yields for Japanese bonds pushed up to 1% for the first time in a year.

Next came an announcement of a manufacturing slowdown in China, with the flash HSBC Purchasing Managers’ Index (PMI) falling from 50.4 points in April to 49.6 for May.  Anything less than 50 points is a contraction.

“And then,” as Zerohedge put it, “all hell broke loose, with the Nikkei first rising solidly and then something snapping loud and clear, and sending the index crashing a massive 1,143 an intraday swing of 9% high to low, leading to an over 200 pips move lower in the USDJPY, and leading to a global risk off across the world.”

Thursday’s 7.3% drop in the Nikkei index was the sharpest plunge since the tsunami hit Japan in 2011.  In comparison, Europe’s leading indexes closed down 2.1%, while in the U.S., the S&P 500 finished the day down just 0.3%, but the day was marked by high volatility.

A Big “If”

Keep in mind that the Fed Chair wasn’t announcing the end of quantitative easing.  He said The Fed may cut the pace of its bond buying at its next few meetings if The Fed sees signs of sustained economic growth.

That’s a big “if.”  The most recently reported unemployment rate was 7.5%, which is still a solid percentage point above The Fed’s target rate of 6.5%.  Then again, we live in an age of diminishing expectations.

Given that The Fed has been buying $85 billion in bonds a month and that quantitative easing has been speeding along non-stop for five years, you’d think a halt to quantitative easing would be long overdue.

A Socialized Bond Market

As a result of its bond buying, The Fed now owns a record 30.5% of the U.S. bond market, including 30.32% of all outstanding 10-year equivalents, Zerohedge reported, adding that the amount of 10-year equivalents held by the Fed increased to $1.583 trillion from $1.576 trillion in the prior week, which reduces the amount available to the private sector to $3.637 trillion from $3.668 trillion in the prior week.

“America may or may not be becoming increasingly socialist and/or nationalized,” Zerohedge concluded, “but there is no doubt about it: its bond market most certainly is.”

But QE is continuing unabated.  QE may not be creating jobs, as was the announced intention, but if it were to stop tomorrow, stock prices would likely plunge, government borrowing costs would rise, The Fed’s portfolio of bonds would decline in value and inflation would increase.

So QE will continue, the federal government will continue spending beyond its means, the dollar will stay weak, interest rates will stay low and unemployment will remain high.

As the stock market continues to set records, the latest Philadelphia Fed Business Outlook Survey shows that the business outlook for manufacturing is weakening.  Of course, that could help continue to boost the market, since it gives The Fed an excuse to continue its quantitative easing.

The overall business outlook is down 5.2% from the previous survey, which is lower than the lowest expectation (a 2.0% improvement was expected).

Virtually all data in the Philly Fed survey were negative, except inventories (up 4.1%) and Prices Paid (up 6.9%).  New orders dropped 7.9% after a 1.0% drop during the previous month’s survey, shipments increased 9.1% last month, but were down this month by 8.5, and the number of employees shrank from 6.8% to a drop of 8.7%.

While the survey indicates weakening activity this month, The Philly Fed reported that “firms continue to expect positive growth over the next six months.”  We’re not sure why.

                                     From “Forever Blowing Bubbles”

Bubbles are everywhere, according to Bill Gross, aka The Bond King.

According to Gross, there’s a bubble in Treasuries, a bubble in narrow credit spreads and a bubble in high-yield prices.  The stock market appears to be in a bubble, too.

The problem with bubbles is that we won’t know we’re in one until it pops.  And when it pops, it’s too late to do anything about it.  A bubble can cause all sorts of problems, as you may recall from the dot-com bubble in the ‘90s and the housing bubble in 2008.

The current bubbles, Gross believes, were created by The Federal Reserve Board, Bank of Japan and other central banks that “keep writing checks and do not withdraw.”  They are blowing bubbles and, “When that stops, there will be repercussions.”

“It doesn’t mean something like 2008,” Gross said, “but it does mean the potential end of the bull markets everywhere – not just in the bond market, but in the stock market and a developing one in the housing market as well.”

Perhaps the only positive is that it will put an end to the Alice-in-Wonderland fantasy existence we’ve been maintaining, which enables the stock market to hit record highs and the bond market to thrive while the economy remains in the doldrums.

As Zerohedge put it, “When you tell the populace that we can all enjoy a free lunch of extremely low interest rates, massive Fed purchases of mounting treasury issuance, trillions of dollars of expansion in the Fed’s balance sheet, and huge deficits far into the future, they are highly skeptical not because they know precisely what will happen but because they are sure that no one else – even, or perhaps especially, the policymakers – does either.”

So it’s good news that a growing number of boomers are postponing retirement.  Today, almost 18% of people older than 65 are still working and the number is climbing.  In 1993, only 11% of people older than age 65 were still working, according to the Bureau of Labor Statistics.

Of course, many boomers will be forced to keep working, because they have not saved enough or because the performance of their retirement portfolio has not met their expectations.

Others, though, will keep working simply because they want to work.

So how will it help the economy if boomers keep working beyond 65?

• Less strain on the Social Security system.  Those over 65 who continue working will be contributing to the Social Security system, rather than taking from it.  Assuming they live to the same age whether or not they retire, they will collect for a shorter period, but their regular payments will be higher.  Every year they continue working, their Social Security payments will increase by about 8%.  Social Security is a pay-as-you-go system; payments from today’s workers go to today’s retirees, so an increase in workers and a decrease in retirees is beneficial.  By 2030, if people retire at age 65, the number of workers per retiree will drop from 4.5 to 3, according to a 2010 study by the Rand Corporation.

• Less strain on Medicare.  Seniors who keep working will in many cases be able to continue using their employer’s health insurance and will not need to use Medicare.

• Less strain on Medicaid.  By working longer, they will also presumably be able to save more for retirement and will be less likely to need Medicaid.

• A lower federal deficit.  Those who keep working will continue to pay income taxes.  The more taxes the government collects, the lower the federal deficit will be.  The continued collection of state income taxes will, of course, help state government as well.

• Lower unemployment.  It may seem counterintuitive, if older employees continue working, studies show the unemployment rate will decrease.   A study by the Pew Economic Mobility Project found that from 1977−2011, every 1% increase in the employment rate of older workers was associated with a slight decline in youth unemployment.  How can that be?  Some older workers will create jobs by starting their own businesses.  Others will contribute their skills and enable their employers to expand.  In addition, if they remain in the workforce, the economy will grow faster, which will create more jobs.  If they retire, they will be a drag on the economy.

Also consider that older employees have many years of experience and knowledge that will be missing in the workplace when they retire.  They may not be as adept at tweeting or using new apps on their mobile phones, but they’ve been accumulating knowledge for decades longer than some of their co-workers.  They simply know more.

Both claims are equally frivolous.

As The Wall Street Journal noted, “The FAA’s all-hands furloughs managed to convert a less than 4% FAA budget cut into a 10% air-traffic control cut that would delay 40% of flights. The 6,700 flights that the FAA threatened to force off schedule every day is twice as many delays as the single worst travel day of 2012.”

With members of Congress among those affected by the flight delays, Congress acted with uncharacteristic quickness and approved a bill to revoke FAA’s politically motivated furloughs.

As for the economy, The Fed’s assessment raises a few issues:

• The sequester took place in March.  It cut this year’s $3.8 trillion budget by $85 billion, or about 1.2%.  Most of the cuts will not even taken place for months.  Yet The Fed is suggesting that sequestration is responsible for the country’s dismal economic performance.

• For sequestration to be a drag on the economy, consumers would have had to anticipate it years ago.  The Great Recession began in 2008 and in the more than three years since it ended, growth has been lackluster at best.  Cumulative growth for three years following past recessions has typically exceeded 15%.  This time, it totaled less than half that – 7.13%.  Is The Fed suggesting that, if not for sequestration, the economy would have finally regained its strength at the beginning of March?

• When the year began, those Americans who are lucky enough to be employed began paying an extra 2% of their income toward higher payroll taxes.  Capital gains taxes, estate taxes and other taxes increased even more for individual taxpayers earning more than $400,000 and families earning more than $450,000. Those making more than a million dollars year saw their taxes increase by an average of $171,300 a year.  Could it be that this $1.6 trillion tax hike has had an impact on the economy?  There’s been no criticism of the tax hike from The Fed, though.

Meanwhile, with the jobs market apparently weakening again, The Fed announced that it will continue purchasing $85 billion in bonds a month though its quantitative easing program (QE3).

What if all of this bond buying is part of the problem, not part of the solution?

The market recovered quickly, as the Associated Press announced that someone had hacked into its computer system and posted a fake tweet about two explosions in the White House.

But the hoax served as a frightening fire drill.  If it had been real, the average investor would have been burned alive.

We’ve warned readers about the dangers of high-frequency trading before.  This is an example of why we’re concerned.  If the White House explosions had been real, the algorithms that make decisions for high-speed traders would have continued selling, leaving the average investor behind as stock values tumbled.

Rick Santelli, on-air editor for CNBC Business News, said high-frequency trading has turned the markets into “high-speed casinos.”

“I have an issue with high frequency, high speed anything that requires nano, nano, nanoseconds to provide the wonderful liquidity we all must have,” Santelli said.  “Is it any surprise that, you know, the average guy on Main Street looks at this and goes, ‘None of this is for me.  You people are all crazy.’ ”

As consultant David Lauer of Better Markets, Inc. put it, “The sophistication of your trading strategy is no longer a defining characteristic of its success, rather the number of microseconds that it takes your software to react to a piece of market data has become one of the most important factors of success in the HFT industry.”

When trading success depends on the speed of your computer, rather than a trading strategy built on insights into market fundamentals, the average investor is in trouble.

Active Management as Antidote

During the Twitter Flitter, our matrix – or order entry screen – was moving so quickly it would have been impossible for any human to react.

The tactical asset management and active investment strategies we use for individual investor’s portfolios, though, are designed to help mitigate risk.  Active management can provide added diversification to smooth market volatility, take quick advantage of opportunities and improve performance.

Last fall, the housing market was showing signs of recovery and the unemployment rate was dropping.  The stock market since then has been propelled upward by the artificial stimulus of quantitative easing.

Now, though, economic indicators are less promising.  The Conference Board reported today that, after three months of gains, its index of leading indicators dipped 0.1% to 94.7 in March.

The index, which anticipates economic conditions three to six months out, was buoyed by higher stock prices and a growing spread between long-term and short-term interest rates, but those factors were more than offset by declines in consumer confidence, housing permits and new orders for manufactured goods.

The U.S. has plenty of company, though, as the International Monetary Fund has lowered its projections for global economic growth in many countries, not just the U.S.  The IMF this week predicted 1.9% growth for the U.S. in 2013, down 0.2% from the IMF’s January prediction.  Some countries, such as France, Italy and the UK, took an even bigger hit, but the IMF prediction for Japan rose 0.4% to 1.6% and for Germany, it rose 0.1% to 0.6%.

In other words, it looks like more of the same, at least for the rest of the year – slow growth and slow progress toward full economic recovery.

Divergence Ending?

The U.S. stock market’s positive performance has a bright spot in a dull economy, as the U.S. economy recently appeared to be diverging from economies in the rest of the world.  Stock markets in other countries have not been setting records and most are nowhere close to their 2007 highs.

The only markets posting positive returns recently have been the U.S. and Japanese markets.  As in the U.S., the central bank in Japan is actively intervening. Markets in Europe and the BRIC countries (Brazil, Russia, India and China) have been lagging.

Many were predicting that a rotation out of bonds and into the stock market would continue to push the market higher.  Instead, as the first chart shows, bond yields continue to move lower, dropping from 2% to 1.68% for 20+ U.S. Treasury bonds.

In addition, the second chart shows that the Russell 2000 could be setting up to drop another leg lower.  If there’s a close below the February 2013 low, we’re likely to see the 2013 gain erased.

And finally, the third chart shows that copper prices are back to their 2011 low.  Copper prices are a leading indicator of what’s happening to the economy.  If the economy were in a growth phase, copper prices would be climbing, not falling.

Some believe America is the least ugly place to invest and that, as a result, money will continue to flow to U.S. markets.  But if we’re expecting money inflows to keep the market rising (scary thought), it’s worth looking at where U.S. multinationals make their profits.  If the rest of the world is in a recession, how will their profits be affected?

Artificially induced market growth can only go so far.

Even the smallest mom-and-pop businesses develop a budget each year and stick to it.  Yet the world’s largest enterprise – the U.S. government – has operated without a budget for more than 1,400 days.  Of course, the mom-and-pop business wouldn’t spend $1.4 trillion more than it takes in every year, either, but that’s another matter.

Nitpickers would say that the government is operating with a budget; Congress just has not passed a budget resolution since 2009.  But it’s the job of Congress to pass and approve a budget – and it has not done so for four years.

As just one example of the absurdity of the Congressional budget process in recent years, consider that when President Obama proposed his budget for FY ’12, the Senate voted it down 97–0.  Every Senator in the President’s own party – even Senate Majority Leader Harry Reid — voted against the budget, even though many had praised it when it was proposed.

Deficit Reduction?

The U.S. Senate passed its first budget in four years in March, but it has as much chance of passing in the House as the House-approved budget, also approved in March, has of passing in the Senate.

Then there’s President Obama’s latest budget proposal, a $3.77 trillion budget which the White House says would cut deficits by $1.8 trillion over the next decade.

Does that mean that White House budget would cut the current debt of $16.8 trillion to $15 trillion 10 years from now?  Of course not!

What the White House is saying is that if the proposed budget were approved (which it won’t be), the projected rate of growth in the federal debt will be $1.8 trillion lower than it otherwise would be.

Unsequestration

Of course, even with that caveat, the $1.8 trillion projection is really a $700 billion reduction, because, among other things, the new budget would undo the sequestration budget cuts, restoring what President Obama called “the foolish across-the-board spending cuts that are already hurting our economy.”

So, if sequestration had not taken place last month, presumably the economy would be booming this month, even though it has been growing at less than 2% a year since the recession ended.

You may recall the angst produced in Washington by those brutal sequestration cuts, which amount to 1.2% of the budget.  While sequestration produced an $85 billion budget cut, everything in Washington gets pushed off as long as possible, so only $44 billion In actual cuts are scheduled taking place in 2013.

Still, that cut was enough to result in furloughs for border patrol agents, the docking of aircraft carriers and the grounding of Air Force combat squadrons, not to mention cancelation of White House tours.

Items still in the budget, though, include more than $700,000 for gardening services at the U.S. NATO Ambassador’s resident in Brussels, $100,000 for walking the First Dog and $221,000 for three calligraphers on the White House staff.

There are also new spending initiatives, including funding for high-speed rail, battery operated cars and more.  Higher taxes on tobacco would supposedly pay for public pre-school education, so if you want to help your children get ahead, take up smoking.

Another Tax Increase

Speaking of taxes, the budget proposal includes about $1 trillion of those, including an increase in the estate tax.

The government would also collect an additional $124 billion over 10 years because of a tweak in the way Social Security payments are indexed for inflation.  This particular “entitlement reform” is getting the bulk of the media attention, but, given the tens of trillions of dollars in unfunded Social Security liabilities, it’s like trying to stop a runaway train with a fly swatter.

According to the U.S. Office of Management and Budget, the federal debt as a share of gross domestic product (GDP) was under 33% as recently as 2001, but will reach 78% in 2014.

Belt tightening is indeed taking place, but not in Washington, where Congress is apparently too ashamed to pass a budget that backs its reckless level of spending.

The U.S. Bureau of Labor Statistics (BLS) reported that the unemployment rate is now 7.6%, down from 7.7%.  But this 0.1% drop is due entirely to a drop in the labor force by 663,000 in March.

Non-farm payroll was expected to increase by 190,000 in March, with the lowest forecast at 100,000.  Instead, it increased by a meager 88,000 jobs.

As Zerohedge.com reported, a record 90 million Americans are no longer even looking for work.  The labor force participation rate dropped from 63.55% to just 63.3% – its lowest level since 1979.

The BLS reports the U-6 unemployment rate for March at 13.8%, which is a more accurate number than the U-3 rate of 7.6%, as it includes those who have been unemployed long-term.

Those no longer participating, of course, include retiring baby boomers, who are making the transition from funding entitlement programs to using them.  The result will be added strains on Medicare, Social Security and Medicaid.

Ignoring Social Security

Social Security is a pay-as-you-go program.  In 1950, there were 16 workers supporting each beneficiary of Social Security.  The Social Security tax today is 70% higher than it was in the 1950s and there are 3.3 workers supporting payments for each retiree.  The Social Security Administration (SSA) projects that the ratio will drop to 2.2 workers pre retiree by 2025 and to 1.8 workers per retiree by 2070.

Yet any attempt to reform the Social Security system has met with resistance from powerful lobbies and members of Congress who are reluctant to make politically unpopular changes to social programs.

More QE

Fewer people looking for jobs will at least reduce the competition for the meager number of new jobs being created.  The dismal unemployment numbers also all but guarantee that The Federal Reserve Board’s quantitative easing program will continue.

The Fed’s goal for QE has been to bring the unemployment rate down to 6.5%, which should be a modest goal, given that it was between 4% and 5% for years until the Great Recession began in 2008.

Yet three rounds of easing, plus Operation Twist, have had little impact on the unemployment rate.

You would think that at some point, Chairman Ben Bernanke, President Obama and others would conclude that quantitative easing is not working and that it should be stopped, even if it is artificially inflating stock prices.

Failure to halt quantitative easing will eventually result in higher inflation, and could even lead to hyperinflation.  QE will continue, though, because all of that bond buying is giving interest rates low and allowing Congress to continue spending, adding $1 trillion or so to the deficit each year ($900 billion this year, but in four previous years the deficit ranged from $1.3 trillion to $1.4 trillion.)

“Our debt levels have grown so high that the only politically acceptable way to deal with them is to inflate the currency,” according to Jeff Clark of Casey Research.  “Politicians and central bankers have no incentive to stop, and thus will continue until disastrous price inflation emerges.  Just because it hasn’t occurred yet doesn’t mean it won’t.

Other political solutions simply aren’t realistic. There is no amount of politically acceptable increase in tax revenue or austerity measures that can meet existing and future obligations.  Printing money is the only viable solution.”

At Least We’re Not Japan

Meanwhile in Japan, where government spending and bond buying are having an even more dramatically dismal impact, as the country continues financial hara-kiri.  As Zerohedge.com reported:

“Just over 4 hours ago we discussed the stunning collapse in 10Y Japanese bond yields. Since then – things have taken a very dramatic turn for the worse for bonds. 10Y JGB yields have exploded higher. The move from 32bps to 65bps triggered circuit breakers on the Tokyo Stock Exchange in JGB Futures trading as JGB prices plunged by their largest amount since September 2002. We can only imagine there is liquidations galore occurring given the massive outsize moves we are seeing in Japanese bonds, stocks, FX, swaps, and CDS. Did the BoJ just lose control?”

In comparison, the Boston area has a population of 4.6 million.  Greece has a population of about 10.8 million.  Central Massachusetts has a population exceeding 800,000.  Would a financial crisis involving two banks in Worcester shake the financial system the way the financial crisis in Cyprus has?

Of course not.  Then again, Worcester is not a tax haven for Russian billionaires, who use Cyprus as their Cayman Islands.  Russia has kept many Cypriots gainfully employed through the country’s two largest banks, Bank of Cyprus PCL and Laiki Bank.

According to The Wall Street Journal, “Bank of Cyprus and Laiki Bank held a combined €85 billion in assets, or five times Cyprus’s gross domestic product, and €58 billion in deposits.  The American equivalent would require multiplying those numbers by 600: $66 trillion in assets, $45 trillion in deposits.  The amount of deposits in all U.S. banks today is around $9 trillion.  Cyprus had become two banks with a country attached.”

Cyprus had requested a euro-zone bailout last year, but the tiny country’s financial issues were largely overshadowed by the financial crisis on the continent.  So the crisis gestated for nine months, before giving birth to a financial monster.

Initially, the island’s banks were closed down, while euro-zone officials contemplated what to do about the latest crisis.  Rather than take the usual path of sending billions of euros along with a warning to not let it happen again, a decision was made to tax bank depositors for the banks’ wrongdoings.

Shareholders Absorb Risk

Understandably, depositors revolted.  A new deal was reached to restructure the two banks and to shift the risk to shareholders, where it belongs.  Bank of Cyprus will be restructured and will take over whatever good assets remain from Cyprus Popular Bank, which will be shut down.  Money held in accounts at Bank of Cyprus will be converted into shares of the restructured bank.

Unfortunately, in the tangled web of finance, nothing is ever that simple.  While Cypriots were left to stand in line this week to take withdraw small sums of money, Russian tax evaders had long since moved on.

Even while the banks were closed, the wealthy Russians who kept their money in Cyprus withdrew their funds through bank subsidiaries in London.

Meanwhile, many others are caught in the financial crosshairs.  Small businesses are suddenly strapped for liquidity and the Church of Cyprus, a major shareholder in the Bank of Cyprus, faces potential ruin.  The Church of Cyprus won an injunction that will temporarily keep the church afloat.

The church is seeking to have its shares converted into shares in the new entity.  However, doing so would create a legal precedent for other shareholders.

If a country as small as Cyprus can create a financial mess of this magnitude, what will happen when the U.S. debt comes due?

The Rest of the Euro-Zone

Cyprus simmered while the rest of Europe boiled over last year.  Likewise, just because Cyprus is on the front page, it doesn’t mean that other European trouble spots are any less troubled.

It turns out, for example, that Spain has been lying about its debt, which is becoming a Spanish tradition.  Many numbers are being thrown around, but how much debt Spain truly has today is anyone’s guess.

Then there’s Italy, with its unresolved election, as summarized by The Economist:

“The election gave a majority in the lower house of parliament to a centre-left alliance led by Pier Luigi Bersani.  But in the Senate the centre-left fell short, and the M5S now holds the balance of power between Mr Bersani’s group and a conservative alliance fronted by Silvio Berlusconi.  That appears to leave other possibilities open.  The first to be rejected was a “grand coalition” of left and right. Mr Bersani ruled this out because a deal with the scandal-ridden Mr Berlusconi would be electoral suicide.  On March 7th Mr Berlusconi was sentenced to a year’s jail for publicising a wiretapped phone call (he can appeal against the decision).  The centre-left proposed a link with the M5S. But Mr Grillo slammed the door on this and accused Mr Bersani of trying to poach M5S lawmakers.”

The only thing missing from the Italian election is hanging chads.  So far, every attempt at undoing the mess has failed.

As in the U.S., nearly five years into the financial crisis, nothing has changed – at least not for the better.