While the mainstream press would have you believe that yesterdays sharp decline in equities was solely in response to increasing commodity prices, and that when the Fed finally ‘pauses’ the Dow will resume its attack on record highs, the reality is that many once distant clouds are not so distant any longer.  For example, if the outlook from technology kingpins Intel, Cisco, Dell, Microsoft, and others is any guide (it was in 1Q00), the long awaited slow down in corporate earnings is extremely close.  Moreover, if statistical and anecdotal information on the US housing market is any guide, the long awaited slow down in housing has already arrived.  That technology earnings are expected to grow less rapidly and the housing ATM machine is in disrepair is cause enough for concern.  But wait, there is more:

US Interest Rates Keep Rising

The normal response to steep declines in US stock prices is that ‘safe haven’ money moves into bonds. As a quick example of this trend, since 2000 the Dow has declined by more than 140 points on 131 different occasions (the latest such instance taking place yesterday), and during these sell-offs bonds (10YT) were also down less 20% of the time.

While yesterday’s decline in bonds can be partially explained by a weak 10-year note auction, not to mention a hefty supply of corporate paper, rising commodity prices are the more obvious culprit. In light of the fact that US retail sales came in soft, the larger speculation to be taken from this action is that a weakening US economy may not necessarily produce an immediate decline in US interest rates. Such a shocking speculation has not been made in nearly 20-years.

So, tech stocks are suggesting earnings slow down, the US housing market has peaked, and US interest rates are taking their cues from commodity prices instead of stocks and the US economy. If these items of interest were not terrifying enough, there is even more:

US Dollar Hegemony Being Tested

Mr. Roach is encouraged that the IMF and G-7 have recognized that ‘global rebalancing’ must involve a weakening greenback. He is also optimistic that a USD decline will “be measured and orderly”, and that a dollar crisis can be averted. With Japan and China hardly embracing stronger currencies and precious metals giving the declining dollar a great big hug, Roach’s new found optimism could prove misplaced. Quite frankly, with Bernanke unable to convey some semblance of policy directionality, some older Roach (Sept 30, 2005) is worth rehashing at this time:

“Greenspan, of course, will not be there to pick up the pieces.  That unfortunate task falls to his successor -- whomever that may be. History tells us that even under the best of circumstances, transitions to a new Fed chairman are fraught with peril.  Financial markets are quick to test the new central banker.  That was certainly the case when Alan Greenspan took over in August 1987 -- the stock market crashed two months later. That was also the case when Paul Volcker became chairman in August 1979 -- the bond market quickly tanked. And the onset of G. William Miller’s brief tenure in March 1978 ushered in a dollar crisis. Just from that perspective alone, there’s good reason to worry about the markets in early 2006. But there’s an even greater reason to worry about the coming transition to a new Fed chairman. Courtesy of bubble-induced distortions that Greenspan condoned, today’s saving and current-account disequilibria dwarf anything that a new chairman has had to face in the past. The average net national saving rate that Miller, Volcker, and Greenspan inherited was 7.4%; today it is 2% and likely to be a good deal lower in early 2006. Similarly, America’s current account deficit averaged -1.5% of GDP in the three most recent Fed chairmen transitions; today, it is closer to -6.5%.

In the end, America’s current-account funding problem remains very much a confidence game…”

If these are the ‘end’ times, the conclusion to be made is that the only thing investors seem ‘confident’ about is that the US dollar is headed lower. To be sure, instead of cheering a falling US dollar as being part of the remedy to an unbalance world, investors and fund managers are selling US stocks, buying commodities, and pushing precious metals up against all major currencies (to be fair, the trend of ‘selling stocks’ is only 1-day old).

Without dwelling on Roach’s flip-flopping, consider what Paul Kasriel has to say. Although Kasriel was referring to Greenspan’s luck with interest rates in the article below, his line of reasoning also comments well on US Dollar movements.

“Just as President Clinton enjoyed the "sweet spot" of geopolitical history in the post-WWII era, I believe that Fed Chairman Greenspan has enjoyed the sweet spot of inflation history. Volcker left Greenspan a great inflation hand to play. Greenspan is more likely to leave his successor a hand similar to that which Miller inherited from Burns. Government spending is on the rise for as far as the eye can see. The U.S. indebtedness to the rest of the world is high and will be rising as far as the eye can see. U.S. policymakers will attempt to lessen the impact of this indebtedness on the standard of living of Americans by running Fed Governor Bernanke's greenback printing press overtime. At first, this will induce foreign central banks to speed up their printing presses as no country right now wants a strong currency. This will lead to global reflation. Later, however, foreign central banks will get that anti-inflation religion again. This will lead to a run on the dollar and a sharp acceleration in U.S. inflation.”  August 22, 2003

Given that global reflation has lead to global tightening, not to mention that as the US dollar declines inflationary pressures are threaten to accelerate, Mr. Kasriel’s insights from nearly three years ago have been spot on.

But why are central banks tightening when traditional inflationary pressures are not apparent/hidden in the government statistics? Because with paper currency wildly chasing stocks, emerging market investments, commodities, and to some extent still real estate, speculative bubbles are at threat of appearing all over the place.  And when these speculative bubbles burst the underlying bubble that supports the entire structure – paper – could itself be at threat. As a gauge of this threat M3 may be gone, but gold is here.

So, tech stocks are suggesting slow down, the US housing market has peaked, interest rate uncertainty abounds, and the trot out of the US dollar is threatening to cannonball into a run.  Things look pretty bleak. But wait, there is one more thing to consider:

Fed Pause is Coming!

When Bernanke presses the pause button popular wisdom says that US stocks will embark upon a record setting relief rally. While this could happen and temporarily stop the clouds noted above from drawing even closer, there is another scenario to consider: Bernanke pauses because the US economy goes bust.

It is difficult to be certain what a sharp slow down in the US economy would mean for US interest rates, the US dollar, and commodity prices (logic says lower interest rates and falling commodity prices). However, what can be said is that a slowing US economy is not a good thing for corporate earnings, and along with the ‘pause’ speculations earnings are all that is holding US equities up.

Investor’s should keep in mind that during these uncertain times ‘news’ events can take on dual meanings (i.e. falling commodity prices could be briefly cheered by equity investors until it is unveiled that prices are dropping because the US economy is in recession).  How long does it take for investor optimism relating to a Fed ‘pause’ to evolve into slow down fears? Apparently less than 1-hour: by the time the morning bell rang yesterday Marketwatch was claiming that the weaker than expected retail sales report was hurting stocks.

© 2006 Brady Willett
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