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Tuesday January 19, 2010 - 18:30:51 GMT
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Forex Blog - It ain’t over ‘til it’s over…

It ain’t over ‘til it’s over…

 

When it comes to financial markets (asset prices and FX), the economy and the policy response, I feel like a sailor at sea in a fog.  My compass tells me port is in one direction, while my sense tells me it is another direction.  Maybe this is a metaphor for the markets more generally – the move up in equity prices and some risk assets (commodities and anything BRIC) reflects the collective sense of the market and is steering the ship, ignoring the compass. 

 

Pardon me while I indulge in some assertions of my own...or what I see on the compass.

 

-          The policy response to date has generated a wall of liquidity that has succeeded in driving up risk asset prices, while saving large financial firms with unlimited zero cost of funding (the ticket to recapitalization).  But the fix for the financial system is no fix at all as the financial system (as bank lending and money supply show) is not performing its primary function in a meaningful way…creating credit for households and firms.  Fiscal stimulus has enabled cash starved state and local governments to keep job rolls filled mainly.

-          However, the policy response from the Fed and Obama administration has failed to do much to get private sector activity going…this is best seen in levels of employment and economic activity (not growth rates which are off very depressed levels).  If the US private sector is not growing at a rate and from a level to generate rising income and employment, then I do not have a lot of faith in a global recovery much less a US recovery apart from new normal stagnation to very modest growth. 

 

-          Firms at the end of the day invest to add capacity and this happens when there is evidence and confidence that revenues are rising or will rise.  I see little evidence of firms reporting levels of revenue gains that favor firms adding to capacity.  Firms have done an excellent job at trimming employment rolls and cutting costs (demanding give ups in supplier pricing) to support profitability.  Yes at the risk of sounding like many skeptics, this is not a path to sustained profitability or a large positive impulse from I in the C + I + G + X equation. 

-          Households are in far worse shape than firms for the most part, struggling under huge hits to wealth and for the unemployed, income.  Households are in no position to drive consumption – trimming spending is a priority for most families and this condition is unlikely to change ahead.  Increasing savings and paying down debt is the new normal for the US consumer… now known as the US saver. 

 

Double Dipping

 

-          Private sector activity is a necessary and sufficient condition for a sustain recovery and simply put I fail to see any rebound in private sector activity in the foreseeable future capable of sustaining US much more global recovery.  Moreover, central banks are beginning to remove the wall of liquidity that has succeeded in driving up risk asset (prices).  While we are some way from the Fed raising the cost of funds for the banks, market rates are very likely nearing a major shift upward reflecting reduced official support for fixed income securities (Gilts in the UK, Agency MBS in the US).  And this is coming at a time when governments and firms are rushing to issue new debt to fund massive deficits (governments) or to get in ahead of the coming jump in market rates.  Higher market rates ahead (including steeper government yield curves) will restrict private sector activity even more.  Yes the US Treasury now has the authority to fill in for the Fed in the GSE market once the Fed exits in March (assuming it does), but I think markets will be far more skeptical of Treasury support for Fannie and Freddie than Fed support.  And US federal government bailouts for cash strapped state governments seems all the more likely (as does an EU bailout for members like Greece – PIIGs). 

 

-          Any chance of a new massive fiscal stimulus in the US may well be shot down if not already by the results of the Massachusetts vote today on the Senate seat vacated by Ted Kennedy…it may well go to the Republican candidate which for many will be viewed as a referendum on Obamanomics…in favor of less government not more.  It would also make life more difficult in the Senate where a 60 vote majority is needed to prevent filibustering (minority can block key legislation with this stalling tactic).  More gridlock in Congress may appeal to some, but if you think the only game in town for growth is the government, then gridlock takes away from this source of positive GDP.  And a loss of the super majority for the Democrats in the US Senate does not make tax cuts any more likely ahead, it just makes tax hikes less likely and if anything all else being equal probably means wider deficits.

 

-          A future of massive debt issuance largely from the government and increasingly from firms facing less friendly bank lines of credit could be in for a major wake up call…a “debt “crisis.  I am not suggesting the bloss of AAA rating for US, as if this would mean much, nor failed auctions, but simply a much higher borrowing cost coming when private sector activity is weak…the road to a spike in market rates and the double dip.

 

Lights out for bonds and equities…dollar and yen safe havens

 

-          My compass leads me to a double dip and another large decline in asset prices…real estate, commodities, equities, EM and spike in risk aversion which should see the dollar and yen benefit as safe havens much as they did through the credit crisis in the second half of 2008.  If I had to bet on when, look for this crisis to unfold as the Fed moves more clearly on withdrawing QE and ultimately conventional policy stimulus in the next several months.

 

David Gilmore

 

 

 

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