September 2007

Sandcastles on the Shore

On September 18th, the Federal Reserve unexpected reduced the Discount rate and Federal funds rate each by 50 basis points, abandoning support for an already plunging dollar on world exchange markets. Meanwhile, lending institutions are closing their doors, hedge funds are going belly-up in numbers, and mortgage backed securities are imploding under unrealistic assumptions and excess leverage. A reporter from Bloomberg notes “The U.S. commercial paper market shrank for the seventh straight week… Debt maturing in 270 days or less continued its biggest slump in seven years, falling $13.6 billion in the week ended September 28th to a seasonally adjusted $1.855 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington.” The previous week’s drop equaled $48.1 billion. The reporter also noted that “the Fed executed a whopping 438 billion in repos (short-term bank loans) in late September, agreeing to take $22 billion in mortgages as collateral. Traditionally, the Fed accepts only Treasuries as collateral.” The Federal Reserve injected additional reserves into the market in late September, matching what it had injected just weeks earlier. To date, the NY Fed (which carries out central bank market operations) has added $38 billion in four separate operations. And, it is not just in the U.S. that pressures are being felt. The European Central Bank announced that in Europe banks are finding it necessary to borrow billions in overnight funds in tense financial market conditions. Add to this fact, the U.S. dollar is reaching all-time lows vis-à-vis the Euro as well as 40-year lows against the Canadian dollar, which now trades at par with the U.S. dollar. As globalization takes hold and the world operates increasingly like a one-world mecca of trade, countries are increasingly talking about un-pegging their own currencies from the U.S. dollar and further diversifying their central bank reserves in non-dollar alternatives like the Euro, Swiss franc, gold or a basket thereof.

In an apparent about-face move, the Federal Open Market Committee reduced short-term interest rates in sympathetic fashion in its latest policy directive. In its previous policy statement, the Fed stated that inflation was the greatest risk to the economy and its bias remained, albeit more neutral, toward increasing interest rates. At that time, the Fed reported that the sub-prime loan and housing debacle showed little sign of impeding growth in the overall economy. How quickly things change. The recent interest rate cut propelled the markets higher with the Dow now sitting less than 1% from its all-time high of 14,021.95. In fact, central bankers have little control any more over what takes place in the modern world given the enormous size of the financial markets around the globe. For example, in early 2001 the Fed began steadily cutting interest rates from the 6.5% level down to 1% and during this time the S&P 500 (the benchmark index) fell roughly 47% from its high. [The markets were in a hyper-extended mode during the tech bubble and we understand that current stock prices are nowhere near that level. Therefore, we do not suspect that share prices will drop to a similar extent in the current market environment.] For another example, during the mid-1990s the Bank of Japan chopped its interest rates to near 0% and held them there for some time while the Nikkei index continued to lose 50% from there. In other words, cutting interest rates alone does not always stave off recession.

The Fed’s September 18th statement reads:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Is the U.S. economy headed for recession? The Fed is showing concern; AIC concurs with that concern. Many gauges – declining new and existing home sales; falling home prices and eroding equity; growing inventories of homes; real job losses; reductions in capital spending by businesses; weak retail sales and durable goods orders; a plunging dollar; rising commodity prices; and probably the greatest threat to a debt-laden economy, a near halt to credit availability – give us pause.

Ironically, the Fed’s attempt at bailing out the housing market by increasing liquidity in an effort to prevent a flow-through to the rest of the economy will probably accomplish just the opposite. The Fed can reduce short-term interest rates and encourage lenders to lend but they still may not. In fact, because of rising risk factors, long-term finance rates actually increased after the Fed cut the Discount and the Fed funds are by 50 basis points. In other words, the banks are being bailed out along with a few large speculators but the people on Main Street holding negative-equity mortgages will never see any of it. [The Administration is encouraging banks to be indulgent to debt-laden homeowners (as if they hadn’t already).] To further make a point, at the beginning of the third quarter the spread between commercial paper and the Federal funds rate stood at 4 basis points. Today, the spread between the two is 62 basis points – to account for added risk.

With the realization that the Fed is not standing behind its “strong-dollar policy” and once again is trying to spend its way out of a natural market correction, foreign holders of U.S. debt are likely to repatriate funds and invest them abroad where interest rates are trending higher and exchange values are more stable. From our sandcastles on the shore, we see the economies of emerging markets growing at double-digit rates, or near, as the U.S. economy retreats to an estimated growth rate approximating 1%-2% for the 4th quarter and possibly into negative territory by the first half of 2008. America’s standard-of-living and quality-of-life are certain to further diminish in the years ahead under the weight of mounting fiat paper and irresponsible governance. If current trends continue, the loss of confidence in the dollar; the loss of good-paying manufacturing jobs; and the loss of consumer’s credit availability, the U.S. economy will be brought to a halt. Investors can offset some of the effects and limit the risks from the aforementioned developing situation by diversifying asset holdings here and abroad, maintaining a conservative investment approach and avoid speculation, and hone in on capital preservation when the quality of earnings erode.