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Thursday April 21, 2005 - 18:41:57 GMT
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Forex: Nervous Markets Ready To Crack

Nervous Markets Ready To Crack

When the largest moves in Tsys, stocks and the dollar in many weeks follow the release of NY Fed Empire mfg index and the Phil Fed business diffusion
index, all is not right in financial markets. Market reaction to these two anecdotal reports on mfg sector have towered over the market reaction this month to a modest Mar payroll gain, record Feb trade deficit, weak Mar retail sales and, for the dollar, a jump in core CPI. Markets are flat out nervous and reduced to reactive day trading. Medium-term view-trading is a fast path to demise. Few near-term views last more than a nanosecond. Think markets are exhibiting a troubling neurosis that should lead to a much larger cross markets move.

Which leads me back to what is the major risk for the global economy? Think if you surveyed market professionals and gave oil and external imbalances as options, the latter would come in on top by a wide margin. Every central banker and many finance ministers agree...US twin deficits are unsustainable. Greenspan today went a step further and said China's currency policy is showing signs of working as a detriment to China's national and economic interests. And in many respects China's accumulation of dollar reserves to stabilize the yuan and support manufactured exports is no longer feasible...as in now. If China's economic policy is at a limit so
too is the US. Without the likes of China buying tens of billions of dollars worth of US debt every month, the US gvt can't count on other investors making up the difference. US rates will rise and US consumption will slow and the external deficit will narrow. How orderly this adjustment occurs is not clear. Japan could return to intervention game if say dollar/yen started to fall under 100, and provide a new source of financing of the US deficit. But this seems unlikely. Like China, Japan currency intervention has reached a limit and more is detrimental to Japan's economic system.

In the Senate today, Greenspan, with a higher sense of urgency than previously in evidence, warned that the US budget deficit path was unsustainable and real progress needs to be made to contain it or there will be undesired consequences. Greenspan noted the need to contain Medicare/Medicaid expenses, suggesting means testing for the former. He urged some mix of spending cuts and tax initiatives to trim the deficit. And he again called for the discipline of pay-go...where tax cuts or spending increases are fully funded. And how did the Senate respond? With interest but no visible sign that any tough fiscal discipline will be proposed much less embraced...not in my committee/backyard mentality.

This leaves us with the White House to lead the US down a fiscal path of prudence. What is the first initiative we see? Establishing private accounts for Social Security that turns out to be a capitalism versus socialism ideologically motivated reform. And it comes with trillions of dollars of transition costs that add directly to the deficit and do nothing to address long-run solvency issues. US Tsy sec Snow and his boss the President promise to cut the budget deficit in half (as a share of GDP) in 5 years. But how? Bush is on record he is waiting for ideas from Congress on tax reform and entitlement reform. But the Bush admin is clear on one fiscal issue...no tax hikes. Hmmm. Free lunch story of supply side economics is so erroneous that it no longer gets any mention. Not even Kudlowvian arithmetic can show the rising tax receipts from record tax cuts in 2002 and 2003.

On the structural imbalances that threaten a disorderly financial market adjustment and likely global recession, there is near unanimity among officials in G20 that the key to order over disorder in the adjustment process is progress in cutting the US budget deficit. Sure this alone will not bring the record US current account deficit into balance. But it will be a step in the right direction and most importantly it will reassure foreign investors who own record amounts of US gvt debt that a AAA rating is bankable. And a serious review of US tax policy that taxes consumption over income will help make America a nation of savers. But this too is beyond anything Washington will do without a crisis first.

However, US Congress and the White House are eager to blame China mainly for the external imbalance and all that needs to happen is for the yuan to float. We all know that this makes about as much sense as setting up private Social Security accounts to cut the US budget deficit and meet long-run liabilities. A gradual move to a floating yuan say over 5 years will do little now to address the budget deficit. If anything it may put upward pressure on US interest rates as China will buy fewer US Treasuries.Be careful what you ask for.

And waiting for Europe and Japan to start growing from domestic demand is like waiting for a new cheap renewable energy source to replace fossil fuels and nuclear power. Actually have more confidence in finding the alternative energy source than domestic driven growth in Europe and Japan.

In other words official inaction is tipping the orderly-disorderly adjustment scale in the direction of disorderly. And the nervous whippy markets in the last few weeks may well be the early warning sign that the markets are nearer to doing what officials seems incapable of doing.

David Gilmore
FXA
www.fxa.com

 

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