BEN THROWS AN ICE CUBE ON THE MELTDOWN
The Well-Timed Strategy for Week Ending August 24, 2007
by Peter Navarro, Ph.D.
with Andrew Vaino
August 20, 2007

NAVARRO’S BIG ECONOMIC PICTURE: SIX QUESTIONS EVERY TRADER WANTS ANSWERED

Why did the Fed cut the discount rate rather than the Fed Funds rate?

The Fed’s injection of liquidity into the system has not been filtering down to the smaller institutions in the most trouble because the big boys are soaking up and hoarding all of the funds.  This was a measured move to hit that segment of the problem.

What is the downside to the Fed lowering interest rates?

The Fed has refused to cut interest rates so far for two reasons.  First, there is concern about inflation being at the top of the tolerable range.  That’s a real fear.  Second, and related, the Fed fears further erosion of the dollar.  Lower interest rates lead to capital exodus and a lower dollar – therefore more inflationary pressures as imports become more expensive.  So the Fed has exercised caution – now thrown to the winds as the markets approach meltdown.

What is the Fed likely to do in September?  Will it work?

The Fed will cut, and probably by 50 basis points in September, but that will push the dollar further towards crisis.  The bigger problem facing Bernanke is the slowdown in key areas of the global economy.  The worst spot is Europe.  It has been a bright shining light the last year or so but it is clearly in trouble now and that’s bad news for American and Chinese exporters.  Another big emerging problem is inflation in China, which has hit a 10-year high.  That’s a bubble ready to burst.  No American Fed is now capable of stemming the global tide one way or the other.  Still a third problem is a wave of “exploding ARM” mortgages that will need to be refinanced in the Fall.  Many won’t have enough equity in their homes for the refi and that’s a time bomb waiting to happen.

Ben Stein got a lot of ink and TV chatter downplaying the significance of the sub-prime meltdown last week.  Is he right?

The U.S. sub-prime market may be small in absolute terms, but its meltdown has not only national but global reach.  If Ben Stein was right, the other Ben – Bernanke – would not be throwing so much credit and liquidity at the markets.  If Ben Stein was right, Countrywide would not have run down its $11 BILLION line of credit in a heart beat.  Conclusion: Ben Stein is dead wrong.

What was all of last week’s chatter about “moral hazard”?

That’s an Econ 101 concept that journalists really sunk their teeth into.  In this case, it describes a system where high risk takers will not be punished by the financial markets for their behavior because the government is riding to the rescue – and that encourages more risky behavior than is optimal for the economy.   In simple terms, we’ve had a situation where mortgage lenders and banks have been doling out money and repackaging the loans and offing them immediately – which lowers the incentives to check credit and terms carefully.   Bernanke deserves more damns than praise for playing a pivotal role in this process.

Has the market found a bottom for now?

Despite ending the week with a bullish bang, the upward trend is clearly broken, technicals are accurately reflecting difficult fundamentals, and traders face more risk to the downside than up.  Bernanke’s gambit is a mere ice cube in a bigger meltdown.  Cash is king for the conservative mind and the short side is the best side for speculators. 

By the way, whenever you hear someone describe this market’s down drafts as “buying opportunities”, chug a beer.  You’ll be drunk all the time between now and Xmas.

THIS WEEK’S BIG MARKET MOVERS

The macro calendar is exceedingly light this week.  Look for earnings reports to be the big mover.  Lowe’s should be interesting on Monday.   Toll Bros on Weds.

TRADE OF THE WEEK: FANNIE MAE (FNM) & FREDDIE MAC (FRE)

Democrats want to Fannie and Freddie to be able to issue bigger loans and more loans and be the lender of last resort in the mortgage market.  Reps and the Bushies think that is a really bad idea, in part because this government agencies are subsidized and therefore compete unfairly in a free market.

Ideology aside, the Dems are likely to have their way on this issue as the problem continues to deepen and broaden.  Both FNM and FRE are showing sharp technical improvement as traders handicap this debate. 

THE CHINA EFFECT

The globe’s financial market meltdown has pushed China off the front pages and TV for now, but that doesn’t mean there hasn’t been some interesting news over the last week.  Here’s my list of the most important elements of the China effect over the last 7 days:

#1: The Iron Lady Does Product Safety: Wu Yi, China’s so-called “Iron Lady”, has been appointed to head a Cabinet-level panel on food and product quality.  This may be really good news because it may signal Wu’s transition from the top trade negotiator role to a more domestic task better-suited to her personality.  To put it bluntly, Wu has been the major impediment to any type of trade breakthroughs each time she and Treasury Secretary Paulson have met at their much ballyhooed but so far totally unsuccessful summits.  Top level Chinese have realized this and this may be a way of getting Wu out the door.

#2: The Latest Chinese Bridge Collapse: A near 1000-ft bridge under construction in Central China collapsed and killed over 50 people.  Speculation has it that inferior building materials may have been the culprit.  This raises the broader question of the quality of building materials we are importing from China to build our own infrastructure.  One rumor, for example, has it that much of the steel in the recent renovation of the SF-Oakland Bay Bridge is coming from China.  On the plywood issue, it turns out Chinese plywood is studded with formaldehyde which can be released as a toxin into homes.   Low quality cement raises foundation issues.  (More to follow on this)

#3: Beijing Cuts Air Flights:  This from the Associated Press – “China's aviation authority, citing safety concerns, has announced plans to scale back flights at overstretched Beijing airport and a ban on the founding of new airlines before 2010.”  That’s all well and good given overcrowding at the Beijing airport but the Financial Times did notice a bit of a “protectionist flavor” to the ban – with airlines that use Chinese-made regional jets getting an exemption..  This is indeed typical Chinese protectionism.

#4: Chinese Inflation: The inflation rate in China has now hit a ten-year high.  This is big news for the rest of the globe, to which China has been exporting deflation for years now.  Runaway inflation in China would be enough in and off itself to roil world financial markets.  Watch this one carefully!

#5: Media Crackdown: And last but not least, in typical Chinese fashion again, China’s response to its wave of defective products has been to crack down on reporters that issue any “negative” news about these events.   What a country.

THE INTERNATIONAL SCENE – TECHNICAL TAKE

There has been a complete deterioration in international markets.  The ETFs below indicate almost every region of the world is now a short.  The biggest bad news here is that Europe is going back into a tank it has spent lo too many years in.   The Continent has been a key part of the global economic boom, but that now is in reverse.  One big problem has been a too strong euro because of Chinese currency manipulation.

*Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

“Any trader or investor who ignores the power of macroeconomics over the world’s
financial markets will, sooner or later, lose more than they should—and if they are
trading on margin, perhaps more than they have.”
 -- If It's Raining in Brazil, Buy Starbucks

The Market Edge Market Summary from www.marketedge.com 

CONTACT INFORMATION
Peter Navarro
Irvine, California USA
Email  |  Website

DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.