Monday, February 21, 2005

Signs of the Economic Apocalypse 2-21-05

From Signs of the Times 2-21-05:

The Dow closed at 10,785.22 on Friday, down slightly (0.1%) from last week's 10,796,01. The NASDAQ closed at 2,058.62, down 0.9% from last week's close of 2076.66. The interest rate on the ten-year US Treasury Bond was 4.26% up sharply from last week's 4.08%. Gold closed at $427.10 (324.60 euros) an ounce, up 1.2% in dollars from last week's $422.00 (327.89 euros) but down 1% in euros. Oil closed at $48.35, up 2.5% from last week's $47.16 close and up 4% over the last two weeks. The dollar lost ground again against the euro, closing at .7650 euros or 1.3072 dollars per euro, down 1.56%. An ounce of gold would buy 8.83 barrels of oil on Friday down from 8.95 the week before.

An ominous, yet realistic, sense of foreboding is starting to break through the happy talk.

Consumer sentiment fell in February for the second straight month, puzzling analysts who haven't been paying attention. Bush's dilemma has always been that to maintain power, to invade countries and to get things like Social Security "reform" done, he has to scare people. Scaring people, however, hurts the economy by destroying optimism.

More attention is being paid to the "inverted yield curve" this past week, due in part to the fact that Alan Greenspan had no explanation for it during his congressional testimony on Thursday and that inverted yield curves always precede recessions. An inverted yield curve is when short-term interest rates are higher than long-term interest rates. In other words, since the US Federal Reserve Board began to raise interest rates (the short-term ones) the long-term rates on ten-year bonds (as well as longer term bonds and housing mortgage rates) have actually gone down. This situation almost always predicts a serious recession.

Here's what the New York Times said in an article by Jonathan Fuerbringer:

When Alan Greenspan says he cannot explain why longer-term interest rates are so low, what's an investor to do? Take cover.

Some money managers are doing just that because they have had the same problem as Mr. Greenspan, the Fed chairman: they cannot understand the decline of longer-term rates despite six increases in short-term rates by Fed policy makers since June.

"This development contrasts with most experience," Mr. Greenspan said last week in testimony to Congress. "Other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields."

Instead, the yield on the Treasury's 10-year note has fallen to 4.26 percent from 4.69 percent at the end of June 2004, despite a climb of 1.5 percentage points in the central bank's short-term rate benchmark, to 2.5 percent. While Mr. Greenspan cited many possible reasons for this unusual happening, he ultimately concluded that "it remains a conundrum."

That's enough to make Paul A. McCulley cautious. "When the Fed chairman says he's scratching his dome, you should be scratching yours," said Mr. McCulley, a portfolio manager and economist at Pimco, the asset management and mutual fund company in Newport Beach, Calif. "You should always be wary when the central bank says an asset price is aberrant."

Thomas H. Atteberry, a manager of the New Income fund at First Pacific Advisors in Los Angeles, agrees. "He's the guy who is supposed to have all the information," Mr.
Atteberry said of the Fed chairman. "And he is telling me he doesn't know why. Why commit capital to a long-term investment when you don't understand why it's valued that way?"

Mr. Greenspan also acknowledged that he was puzzled by other economic behavior. Although investors seem willing to take on more risk, businesspeople appear reluctant to do so. Capital investment has lagged behind the big rise in corporate profits. And worker productivity, a factor in restraining inflation, has proved to be "notoriously difficult to predict," he said.

There were other disturbing aspects to Greenspan's remarks. Greenspan said to Congress on Thursday that by permitting the further growth of federally backed mortgage companies, Fannie Mae and Freddie Mac, "we are placing the total financial system of the future at a substantial risk" [Read full article]. That is apocalyptic language for Greenspan. Fannie Mae and Freddie Mac are government-chartered companies that buy up mortgages from private lenders. They are also privately owned by shareholders, but they enjoy the perception by the market that they are federally backed, since investors don't think that the government can let them fail for social, political and economic reasons. Since 1997, their holdings have tripled, growing to $1.5 trillion.

Greenspan urges cuts at Fannie, Freddie

Fed chief says $1.5 trillion mortgage portfolio will cause problems for nation's financial system.

February 18, 2005: 9:19 AM EST

(Reuters) - Federal Reserve Chairman Alan Greenspan urged Congress to significantly cut the mortgage portfolios of the big mortgage firms Fannie Mae and Freddie Mac to avoid "almost inevitable" problems for the U.S. financial system.

Greenspan has in the past expressed concern about the growth of the companies' mortgage holdings, saying they could pose a risk if allowed to increase unchecked. The Fed chairman went farther Thursday, telling members of the House Financial Services Committee they should require the companies to slash their mortgage holdings.

Congress is weighing tighter supervision of the mortgage finance companies after accounting controversies and senior management ousters at both firms in 2003 and 2004.

Fannie Mae and Freddie Mac buy home loans from lenders and repackage them as securities for investors, but they also retain mortgages and mortgage-backed securities for their portfolios.

Congress chartered the shareholder-owned companies to ensure there are plenty of funds available for home buyers to take out mortgages. Greenspan said in response to lawmakers' questions that the growth of those portfolios, which together top $1.5 trillion, primarily allows the companies to leverage their federal charters to generate substantial profits.

"We have found no reasonable basis for that portfolio above very minimal needs and what I would suggest is that for liquidity purposes they're able to hold U.S. Treasury
bills in whatever quantity they would choose ... and a $100 billion, $200 billion, whatever the number might turn out to be, limit on the size of the aggregate portfolios of those institutions," he said.

A Freddie Mac official disagreed with Greenspan, saying that Freddie Mac's mortgage and mortgage-security purchases pump money into mortgage markets, lowering costs by boosting demand and guaranteeing stability even during unsettled periods, such as the Asian debt crisis of 1997-1998.

"Our retained mortgage portfolio helps us fulfill our charter purposes of providing liquidity and stability to the U.S. residential mortgage market in good and bad economic times," said Freddie Mac spokeswoman Sharon McHale.

But Greenspan said congressional failure to cap the growth of the companies' mortgage portfolios would invite potentially serious risk. He recommended that lawmakers pass legislation within several years requiring Fannie Mae and Freddie Mac to divest a large share of their holdings.

"Over time, several years, that should be done because these institutions, if they continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios which they need to do for interest risk diversion, they potentially create ever-growing potential systemic risk down the road," Greenspan said.

While there is no risk now, problems are "almost inevitable" in the remainder of the
decade if lawmakers fail to act, he added.

"If you get large enough ... and something goes wrong, then we have a very serious problem, because the existing conservatorship does not create the funds which would be needed to keep these institutions going in the event of default, which is what the conservatorship is supposed to do, and we have no obvious stabilizing force within the marketplace," he said.

"Enabling these institutions to increase in size -- and they will, once the crisis passes ... -- we are placing the total financial system of the future at a substantial risk," Greenspan added.

Criticisms of Greenspan's tenure as Fed chief have grown louder in recent months. A headline for an article at screams, "World on Brink of Ruin." That is not the kind of language publications like Forbes usually use. Is there an effort to scare the public to cause a crash? Or are they covering themselves because they know it will happen soon? Here is what Forbes said about Greenspan:

Alan Greenspan, that Matador of the Money Supply, the esteemed Impresario of Interest Rates, has suffered precious few slings or arrows over his many years as chairman of the Federal Reserve. Even the White House has had to offer its critiques off the record for fear of roiling the markets or upsetting the chairman's Elvis-in-Vegas-like following. So when the chief economist of one of the world's most prestigious banks calls Greenspan a bum, that's a big deal.

And yesterday it happened. Stephen Roach, the chief economist for Morgan Stanley & Co., one of the most powerful investment banks and one of the 50 largest companies in the world, says Greenspan has "driven the world to the economic brink."

Writing in an upcoming issue of Foreign Policy, Roach says that when Greenspan steps down as chairman of the Federal Reserve next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Americans, Roach says, are far too dependent on the value of their assets, especially their homes, rather than on income-based savings; they are running a huge current-account deficit; and much of the resulting debt is now held by foreign countries, especially in Asia, which permits low interest rates and entices Americans into more debt.

Here's Marshall Auerback:

Economists, politicians, and business executives have repeatedly voiced unease about the imbalances in the global financial system, which have been reflected in the dollar's steep fall against the euro and other currencies until recently. But most expressed skepticism that the Bush administration would reduce the trade and budget deficits, which have fed those imbalances. The White House has said that it does not view these issues as a major problem because foreigners still view the American economy as an attractive investment, and Mr Greenspan has recanted some of his earlier expressed concern about the dangers of ignoring America's mounting imbalances.

The scope of the global imbalances and the potential for crisis makes piecemeal, orthodox solutions to the global imbalance problem unworkable and far too slow. The U.S. service-based economy, with more limited economies of scale than those of newly industrializing economies such as China, will not be able to export its way out of the problem. The only demand left for US goods is largely concentrated in industries such as aerospace and high technology. But these are industries where exports pose national security risks, particularly if the exports are directed toward "strategic competitors" such as China, which generally have extremely poor records in terms of safeguarding intellectual property rights.

As we have noted many times before, there is a danger that over time, the US economy will find itself in a "debt trap", with an accelerating deterioration in its net foreign asset position and its overall current balance of payments (as net income paid abroad begins to explode). We have never been in a position before where the world's leading economy has been subject to this condition, so it is difficult to make the case for traditional remedies, such as trade devaluation (where the corresponding knock-on effects would invariably create a huge international growth shock, thereby throwing into doubt the strategy of the US achieving net export growth). Because the US is such a vast economy, it cannot eliminate its current account deficit as readily as a smaller economy. When it tries to improve its trade balance through devaluation or through restrictive demand management, its sheer size affects the economies of its trading partners adversely and to an appreciable degree. Understandably, they object and resist. When foreign economies resist dollar devaluation and the dissipation of their current account surpluses, the U.S. may have to raise interest rates in order to induce creditors to continue financing its debt build-up.

So the problem is likely to get worse, which could ultimately lead to "solutions" that prove highly disruptive to the existing system of multilateral trade and cooperation which has developed over the past several generations. A resort to out and out military force cannot ultimately be ruled out.

If a full-blown crisis does occur, the macroeconomic challenge would be unlike anything the United States has faced in more than half a century. While this would be a time of wrenching, painful change, the new adverse circumstances might also inspire a great shift toward radically different political solutions than have hitherto been considered within the realm of acceptability.

The first imperative--an unavoidable necessity--would be to suppress consumption through credit-restraining measures, fiscal caution or tax reform, and to stimulate greater domestic savings, yet somehow to keep the economy growing. If this great adjustment is left to market forces alone, the predictable consequences will be to punish the innocent--struggling households and small businesses--first.

The jump-shift strategy may ultimately take the form of a "wartime strategy" – not the phony "war on terror" strategy invoked after the September 11, 2001 attacks (in which Messrs O'Neill and McTeer, amongst others, exhorted Americans to go back to the shopping malls, to show the terrorists that they "couldn't win"). A more accurate precedent is World War II, an extraordinary era of economic development that virtually shut down many forms of domestic consumption (cars and housing) while the government's spending on war production launched major new industries (electronics, petrochemicals, modern aircraft and many others). Essentially, accelerated investment and forced savings replaced consumer spending as the leading fuel for economic growth. After the war, pent-up desires and needs became the economic demand that drove the long postwar era of prosperity.

Of course, an important difference from the World War II example is that it is
difficult to see how reconstruction could be financed primarily through deficit spending, given that the country is already burdened by growing indebtedness. This leads to the possibility of the US repudiating its existing debt obligations to external creditors. A decisive President might start by bringing up a taboo subject--tariffs--and inform the world that the United States is prepared to impose a temporary general tariff of 10 or 15 percent on all US imports. Every multinational would have to rethink its industrial strategy, because some of its production might be stranded in the wrong country.

The idea of tariffs is so alien to conventional wisdom it probably sounds illegal. In fact, there is provision for "temporary adjustments" under the new World Trade Organisation rules. It is also worth noting in any case that the legal technicalities of a global multilateral system didn't stop Richard Nixon, who stunned the world in 1971 when he abruptly announced a 10 percent import surcharge, devalued the dollar and unilaterally discarded the Bretton Woods monetary system. Nor did it stop President Roosevelt in the 1930s, during which he declared it illegal to own circulating gold coins, gold bullion, and gold certificates. In essence, the federal government forced itself into the position by refusing to repay its bond holders in gold coin, forcing them to accept US dollars instead. Hence, subsequent to FDR's executive order, all holders of such bonds were forced to accept legal tender currency instead of "gold coin of the present standard of value." The act of confiscating gold itself was a violation of private property rights and was illegal – but the taboo was broken. As author Eric Englund notes, "[B]y not paying bondholders in gold coin, the U.S. government has technically defaulted on past Treasury bond obligations." Americans (and their foreign creditors) might come to see more of these types of actions from future American President.

It is true that such actions on the part of the US may well provoke reactions in kind. On the other hand, given the lack of restraint evident in the country's current foreign policy aspirations, it is hard to envisage that an economic response to the Americans' abrogation of existing obligations would come without some possibility of a robust military response (or at least the threat of one). The US has already show itself willing to address the problem that it does not make enough of what the rest of the world wants by going to war to monopolise control of the supply and distribution of what the world needs, petroleum. There are other war aims, of course, but control of the global hydrocarbon net is certainly the most important. As market strategist Chris Sanders has noted, "The truth is that the dangerously destabilising idea has rooted in Washington that, in the words of Vice President Cheney, 'deficits don't matter (we proved that in the 90s).' He is right of course in pure power terms; a fuller expression of Cheney's dictum might well add, 'as long as we are able to force everyone else to accept them (deficits).'"

Already, it appears clear that the US is driven to rely more on military adventure because the economic house is in disarray and "overstretched". They can't just bludgeon their way economically anymore. They have to use the stick. Any close look at the inauguration speech bears out the reliance on forcing the world to conform to us dictates. Why should this not extend ultimately to existing debt arrangements if the US finds itself facing an Argentina-like predicament? All these outcomes may sound quite improbable at this moment. Certainly, the establishment would brush them aside. But do not dismiss the possibility that dramatic change and epic political reforms lie ahead. As we have said many times before, Washington's elites will not go down without a fight.

A guest commentator on, Max Fraad Wolf, advises us not to listen to the happy talk, but to think:

Indexes drift upward pulling predictions, expectations and your leg. It is high time to more profoundly question the wisdom being peddled by the Fed, administration and financial press. I strongly recommend that investors listen less and think more.

Let's start with the basics on which most agree. 2005 will see a deceleration of S&P 500 profit growth. US GDP growth will also likely decelerate. The consensus 2005 estimate from the Economist magazine is for 3.5% GDP growth down from 4.4% in 2004. US interest rates and monetary policy will remain stimulative, but less so, as they meander toward neutrality. As this goes to press, broad and narrow US money supply growth is above, and interest rates are below, long term historic norms. This can only continue if we double dip. Huge trade and budget deficits, near or above 2004 record levels, are a virtual certainty. Yes, you listened to Greenspan assert that weakening dollars will suddenly reverse a 15-year secular trend in trade imbalances. He mentioned this as another weak job report was issued, but didn't bother to base his claim on any particular fundamentals. That presents an opportunity to implement the new credo, "don't listen, think."

If you follow this simple rule, your rose-colored goggles will fog over as your temperature rises, and you will be driven toward their removal. No sooner than you slip off those worn out lenses, will you find the following puzzling:

A merger wave seems well established. You have been listening to stories about how this is a great omen for stocks. Stop and start thinking. Over the past five years we have discovered that most of the last great merger wave's shining stars are light years away from real enduring benefit to share holders - from AOL- Time Warner to HP-Compaq.

Secondly, the drivers to the mega-mergers are pricing power, competition reduction and cost cutting opportunity. That explains much of the recent activity, and it also
signals discomfort that leading businesses have with investment in their own industries. Amidst monetary stimulus and hype, firms are looking to hunker down, remove competitors, slash costs and pass along material price increases to debt burdened consumers facing declining market choices. In addition, several major firms are looking to invest repatriated profits- at the new much lower tax rates on these funds. However, they seem disinterested in capital investment or hiring. This is supposed to reflect a healthy environment for stocks.

How many times is a turn in events Iraq right around the corner? Iraq's recent vote
propelled Shia religious leaders and secessionist Kurds into dominance alongside an apparently growing insurgency. This is not the kind of news that rationally leads to popping corks and fine cigars. Yes, it was nice to see that many voted despite the credible threat of death. However, this hardly justifies the Iraq victory premium in the markets, let alone a further run up. Look at the latest issue of Foreign Affairs. In it you will find leading experts extolling their considered "best" option, rapid withdrawal. Is it plausible this suggests that they have been thinking, not listening and are not impressed?

Chronic bulls simultaneously celebrating the ability of declining dollars to overpower trade deficits and the reassurance offered by rising dollars amid forecasts that call for the dollar to end the year at or above where it began. We are told variously that declining greenbacks are helpful, trade rebalancing and likely to reverse direction. Sounds great, but doesn't stand up well to the application of reason. Negative balances of trade are built into our macro economy and our place in the global economy. These imbalances will not substantively change unless the structure of the US economy or the global economy does. Our earnings are insufficient, our savings non-existent and our demand insatiable. Our place is to borrow and spend. Correction of the imbalances would require this to change. Few even acknowledge that possibility, yet they endlessly forecast either painless correction or the sustainability of the present arrangement. Both offer reassurance and buoy sagging spirits and prices. Sadly, they are little more than howling gusts of hot air Prozac. If you listen, you will feel better. If you think you will feel worse.

US equities are not cheap and neither is the dollar. Thankfully, this is not very widely understood. Thus, the safety offered by the mob. To stay happily in the game, one need only ignore reality. Look no further than Greenspan for an impeccable role model.

Of course, you are safe in the mob until the whole mob runs off a cliff. Better to think objectively and face reality.


Post a Comment

<< Home