Yesterday, the world had a chance to take a better look at the Fed’s latest rate cut…
“Yecch,” it said. And so “Hell Week” continued.
Despite the Fed’s intervention, in both London and New York the cost of money for most borrowers actually went up.
“Fed cuts fail to lower 30-year mortgage rates,” notes the Los Angeles Times . At the long end of the yield curve, rates are determined more by fear of inflation than by the Fed’s price fixing. Thirty-year fixed-rate mortgages have gone up from 5.6% to 6.4%.
But even at the short end, where the Fed is pressing its fat thumb on the scale, “Money market rates rise as banks hoard cash,” says a Bloomberg report.
The banks are holding onto their money because they figure they might need it. That’s what everyone does in the opening stages of a credit contraction. They’re afraid that if they lend it out…they will later discover that the borrower can’t pay it back.
Yesterday brought news that two big borrowers had gotten whacked. Endeavor Capital lost 28% trading Japanese bonds. And poor John Merriwether! Almost exactly 10 years ago, the man’s Long-Term Capital Management went broke. Now, the news tells us that his bond fund has just taken a 24% hit.
And Britain’s biggest mortgage lender – HBOS – denied rumors that it is having liquidity problems.
The Fed giveth.
Mr. Market taketh away.
It’s “the Great Unwind,” says Citigroup. What is being unwound is the ball of debt, derivatives, speculation and outsized asset values all over the world.
The Dow fell yesterday – down 293 points. Commodities got whacked hard too. Oil lost nearly $4 a barrel. Gold dropped to $945. And copper – which tends to be an indicator for the whole economy – seems to have topped out.
In terms of our ‘battle’ between inflation and deflation, yesterday, deflation won.
*** In spite of all the bad news, Hell Week hasn’t really been so bad. It’s more like Purgatory or Limbo…or a halfway house after coming out of state prison.
The headlines speak of a worldwide financial crisis, but so far, the effects of this crisis are extremely limited. The OECD reports that unemployment around the globe is only 0.3% higher than it was a year ago, the same figure U.S. unemployment has risen during that period.
Aside from panicky capital markets, some areas don’t seem to be suffering at all. Latin America, Asia, the Gulf, and Africa all seem to be growing, with no significant economic effects – at least, not yet.
The Financial Times summarizes the outlook for the world’s major regions:
In the United States, people wonder how hard the landing will be.
In Europe and Japan they wonder whether the landing will be hard or soft.
In the rest of the world, they ask whether they will have a landing at all.
America’s central bank is now lending money at about half the rate of consumer price inflation. A borrower can take the money and almost certainly make money. If nothing changes, he’ll pay back money worth less than the money he borrowed…or, he can put it on deposit in Britain at twice the yield…or in Brazil, where he’ll get 5 times the yield.
The lower rate is intended to encourage borrowing. Whether it also encourages consumer spending, hiring, and capital investment is another whole group of questions with very uncertain answers. If the answer is yes…you can reasonably expect further inflation in the commodities markets…rising stock prices…and a positive GDP growth. If the answer is no…you can expect higher unemployment, falling stock and housing prices…and probably falling commodity prices too.
While yesterday was clearly a ‘no’ kind of day…there is no guarantee that every day will be a ‘no’ day.
Another way to look at this is a way long time Markets and Money sufferers will recognize: it is our familiar battle scene…with the heavy cavalry of inflation charging the steadfast infantry of deflation.
While that picture has fairly well described the financial world for the last year or so…we think it is time to add a complicating feature. It is as if a third army has appeared on the field of battle…of unknown size…and unknown intentions. So let us review the battle lines.
On the one side, is the familiar force of a credit cycle downturn…believed, by us, to be the beginning of a major contraction in the credit market. These things are big. The last big force in the credit world was the expansion that began in 1980. Obviously, it lasted for 25 years, perhaps a bit more. That expansion seems to have come to an end. Yields are about as low now as they were when the last expansion began…and probably turning up.
That “probably” is an important word. Recently, yields have been going down, as investors sought safety from default over safety from inflation. Looking for protection in the treasury market seems to us a bit like looking for veracity in the U.S. Congress…and we suspect that when things settle down, investors will realize they’ve made a mistake.
“The credit crunch is rapidly morphing into a credit collapse,” says Harvard’s Kenneth Rogoff. “The same factors that propelled the housing bubble are now spinning in reverse. And there’s no bottom in sight.”
On the other side, of course, is the other familiar force – inflation. It’s what you get when you favor the production of ‘money’ over the production of the things it is used to buy. Inflation is clearly driving up some prices. Oil is holding over $100. Gold has been on a tear for 8 years. Rice just hit a 32-year high. CNNMoney reports that inflation is Americans’ number one concern.
Meanwhile, keeping our pict-o-rama of the world’s financial scene before us, with inflation on the left, deflation on the right, down the center comes a huge, disorganized, polyglot collection of fighters – lean and hungry – emerging markets, oil producers, former Soviet republics…the bric-a-brac of humanity.
While deflation knocks down commodity prices – these emerging economies are buying them as fast as they can.
While inflation is pushing up automobile prices – they’re making new cars for only $2,500.
While deflation cools the U.S. economy – these third world economies are still heating up.
While inflation squeezes aging, middle class families in the West – in the East, millions of young, new families are becoming middle class, bursting at the seams with new consumer demand.
What will happen when these three armies collide?
We don’t know…but we’re watching…
*** Mentioning 1998 brings back memories. That was when people still believed the promise of the dotcom era. They thought new technology and capitalism would make them all rich. They ran up prices on Wall Street in anticipation.
And then we came up with a hypothesis: that when the tech bubble burst, the U.S. economy would sink into a long, slow Japan-like slump. With Addison, we wrote a book on the subject – Financial Reckoning Day – arguing that central bank wizardry might be able to stop inflation, but it had never proven that it could cure a deflationary slump. Even a bad central banker can stop inflation, if he has the backbone for it. The reason for this is almost too obvious; central banks can stop inflation because they are the ones who create it.
But deflation is the markets’ revenge…and central bankers have never shown they can stop it once it gets going. That is what we learned from the Japanese in the ’90s. You can use all the fiscal stimulus you want…and all the monetary stimulus too. It doesn’t mean the economy is going to pick up.
We’re beginning to think we were right in Financial Reckoning Day . Or almost right. Yes, dear reader, we said that after the tech bubble popped, the U.S. economy would enter a long, slow slump, a al Japan. Obviously, we were too early…there was one more big bubble still to go – in residential property. But now that that bubble has come and gone, here we are again – possibly facing another Japan-style funk.
*** “It’s no secret: Homebuilding stocks have performed horribly,” says our colleague Dan Amoss. “Most are 60% or 70% below their highs. A few regional builders are in the low single digits, drowning in debt and heading to zero.”
“But stocks never move in a straight line. The sector has enjoyed a massive short covering rally since late January. Most are up 40% or more in a few weeks. This gives us a good short selling opportunity.
“Homebuilding bulls are hoping for a quick housing market recovery, because they need one for the stocks to have a sustainable rally. This spring, as selling season kicks off, you’ll start hearing ‘affordability’ arguments from housing bulls in the media. I suggest ignoring them.
“Housing bulls fail to appreciate how the easiest mortgage environment in history magnified every homebuyer’s purchasing power. They also focus on monthly payments in a 5-6% mortgage environment, without incorporating the burden of falling house prices. Incomes and 5% mortgages can support housing prices in many areas of the U.S., but not in areas like Las Vegas, Phoenix, and most of California and Florida.
“Measured over a full boom-and-bust cycle, homebuilding is not a great business. Even at the peak of the housing bubble, most builders’ operating profit margins maxed out at 15%. This business is capital-intensive and requires a rising house price environment to thrive. The most aggressive homebuilders loaded up on raw land at inflated prices and levered their balance sheets with visible and hidden debt. Now most are liquidating inventory as fast as possible, even at steep losses.
*** What are they putting in the water in New York? Has no one any sense or dignity?
First, Eliot Spitzer confesses to a mortal sin and resigns his post as governor of the state. Then, his replacement goes before the cameras to make a similar admission – even before he’s accused of anything.
Then, it gets even tawdrier. His wife, for no apparent reason other than to frolic in the sewer with the two governors, revealed that she too had done things that would make her eligible for death by lapidation in other countries. But this is New York, remember. She’ll probably go on Oprah instead.
And, as if all this weren’t absurd and pathetic enough, we discover that New York’s new governor and his wife went to the Days Inn on upper Broadway and 94th Street in order to bring more excitement to their married life. The Days Inn?
At this point, your editor notices his stomach seizing up…and beginning to convulse. He doesn’t know whether he is going to laugh, or be sick.
Markets and Money