Economy Watch:  While most commentators harp about rising inflation, I believe the largest threat looming over the market is that of deflation…an uncontrolled systemic deleveraging.  I put the presentation below together March 7, a stripped-down version of which we gave to some of our advisors on March 11.  In it I hit on what I believe are three of the four big threats to the financial system: the continuing fall/deflation in house prices; the chain reaction in the credit markets following the subprime blowup; and the massively over-leveraged position of ALL the Wall Street investment banks.  These three factors point to the threat of debt deflation, which leads to asset deflation, which eventually leads to price deflation.  The other big threat is that of the falling currency, which is inflationary and currently masks the deflationary effects of the deflating housing/debt bubble.

Download market_update_31108.pdf

The key point is that Merrill, Morgan Stanley, Lehman, and to a slightly-lesser extent Goldman all have leverage ratios similar to what Bear Stearns had.  While the other banks may have managed their liqudity and liabilities better than Bear, and have a more diversified set of assets, they all operate with the kind of leverage that killed the LTCM hedge fund in 1998.  A shout-out to Portfolio Magazine for clueing me in to this back in October.

Anyway, in this weekend’s actions the Fed may have averted the worst of the disaster scenarios: the uncontrolled collapse of a major counterparty to credit default swaps, prime broker and holder of mortgage securities that would have cascaded through the system.  The free-market ideologues (and this comes from someone who is about as free-market as they come) that say the government shouldn’t have gotten involved are completely underestimating the risk of total disaster that hangs over the markets like the sword of Damocles.

The rescue of Bear Stearns’ creditors and customer accounts was important, but another Fed action over the weekend may ultimately prove to be more important: making Fed credit directly available to the brokers.  In this, the Fed has acknowledged that much of the financial system’s credit is now created by brokers and their hedge fund clients.  This is likely the first step of a process that will bring brokers and potentially hedge funds under Fed supervision, forcing them to delever and likely to end up being merged into commercial banks.  For the broker/hedge fund universe to be operating at an overall leverage ratio of 30:1 to beyond irresponsible and puts the whole American economy at risk.  The risk management models used by the investment banks have underestimated the risk of disaster and have led to the type of hubris that could bring the entire financial system to its knees.

Inflation is created by the expansion of credit.  The Wall Street investment banks and hedge fund community expanded their leverage outside of Fed supervision, so that while M1 was flat for years, inflation was running rampant through the housing and commodity sectors and credit creation was leading to artifcially stimulated demand and an ever-wider trade deficit.  Those distortions have lead to unstable currencies, increased protectionism, militarism and anti-immigrant sentiment…the same toxic mix from which emerged the right-wing populism and communism of the 1930s.

A wholesale re-thinking of monetary policy is required.  Currency stability should be given more primacy, so as to prevent the rolling financial crises, volatile commodity prices and large trade deficits that we have experienced over the last twenty-five years.  That means interest rates should be more stable.  Instead, the Fed should target leaning against the wind on credit creation itself, particularly via bank reserve requirements, repo collateral requirements and derivative exposure.  If we don’t start brining some order to the global financial casino and the instability that goes with it, we risk giving rise to alternative ideologies to capitalism that will ultimately destroy prosperity.

Economy Watch:  When I made my list of 10 Potential Surprises on December 24, I didn’t expect one to come true so fast.  Potential Surprise #5 has come to pass.  The Fed Funds rate is now at 3%, with the potential to go a bit further to the down side.  Another of my surprises is looking promising – #10, that John McCain would be the Republican nominee.

Another now looks like it will certainly not come true, #9, that John Edwards would be the Democratic nominee.  As I said in my December 5th essay, Assessing the Presidential Race, I thought John Edwards was the best general election candidate.  I probably overestimated how good Mike Huckabee would have been, but I stand by my analysis that John McCain is a better general election candidate than Hillary Clinton.  I acknowledge that the tide is swelling Democratic big-time this year.  For that reason, I don’t guarantee that McCain would beat Clinton, but I do think he’s the best shot the Republicans have this year.

I stand by, with trepidation, my prediction that the economy will avoid recession this year.

Economy Watch: BusinessWeek (go to chart 4, but the whole slide show is interesting) has a cool chart graphically depicting the "Great Moderation" in GDP growth over the past 20 years.  Maybe the Fed knows what they’re doing after all…

Economy watch:  I like to invest by focusing on the big things and getting on the right side of the big trend.  There is alot of day-to-day noise that can distract me, and I try my best to tune it out.  This decade there have been four big things to get right, and if you got them right, you have invested well.  The four are: (i) the reversion of the dollar to its long term trend from its 2001 high; (ii) continued globalization; (iii) the rise of digital consumer technology; and (iv) the blow off top in the global real estate boom.

Today I will focus on the creation and bursting of the real estate bubble.  First a chronology:

1. In 2001, the US experienced a recession during a period of extreme dollar strength and following the bursting of the telecom bubble, a credit crunch on businesses.
2. The combination of a strong dollar and credit crunch created the threat of deflation, which the Greenspan Fed responded to by lowering the Fed Funds rate to 1%.
3. Even when the credit cycle turned up, Greenspan kept rates at 1% for an extended period of time, resulting in an incredibly steep yield curve.
4. A steep yield curve encourages high leverage.
5. In the meantime, the dollar was starting to fall.  East Asian central banks propped up the dollar by recycling dollars used to buy their exports into US treasury and agency securities.
6. With this inbound liquidity flowing and interest rates low, the credit boom was primed.
7. The demand for credit investments encouraged the creation of asset-backed CDOs to satisfy investor demand.
8. Low interest rates, easy money, positive demographics and a long running trend of positive residential real estate returns, encouraged a speculative frenzy in real estate.
9. Armed with sophisticated math models using normal distributions for default rates, CDO sponsors convince the rating agencies to assign higher-than-deserved ratings for various tranches of the securities.
10. Investors, relying on rating agencies because the complexity of the products was too opaque, were attracted to the securities for their relatively high yields (also due to lack of liquidity).
11. Mortgage originators, incentivized to originate mortgages and sell them off, did what they were incentivized to do, albeit sometimes by cutting corners.
12. In the meantime, the Fed is raising rates in predictable 1/4% increments.  The predicibility at first encourages speculation.  But since the credit boom and resulting inflation raged on, Bernanke kept raising rates to 5.5%.
13. The housing bubble popped as high interest rates and high house prices reduced affordability.  Subprime borrowers began defaulting on their loans (that often had no equity down), house prices began to fall, credit hedge funds began running into trouble and the whole process started to go into reverse.

Everyone in the chain of events is to blame.  But I assign different levels of blame.

Whom I blame the most (because they created the incentives for the bubble):

• Alan Greenspan (for not raising rates faster and sooner)
• The Peoples Bank of China (for building currency reserves to  promote their own exports)
• The rating agencies (for not realizing that defaults are correlated and that the model should have fatter tails)
• Anyone who committed fraud

Whom I blame less (because they were reacting to conditions):

• Borrowers (hey, they give me cheap money with no equity down, I’ll take it)
• Mortgage Originators (hey, you pay me to sell you mortgages, no matter what the quality and with no documentation, fine, I can sell those all day long)
• Wall Street (hey, we’re just doing what we always do)
• Bond Investors (hey, the rating agencies said this was AAA)
• Ben Bernanke (hey, there was an inflationary bubble going on, how can I not raise rates)

The housing crash still has a ways to go.  Demographics are now working against the market, and while house prices fall, its impossible to know what all the CDO securities are worth.  Of course its a vicous cycle, because as the financial institutions take write-offs to CDOs their equity bases shrink and general credit is restricted, which makes the economy worse and housing prices fall more, which in turn cuases more write-offs to CDOs.  Such a scenario is called DEFLATION.  Right back at ya, Greenspan.

Economy Watch:  The economy of China is careening toward disaster and they have no one but themselves to blame.  The mercantilist Chinese policy of building dollar reserves is fuelling not only a preposterous speculative bubble within China, but also in the commodity markets worldwide, and formely in the US housing market (abetted by Wall Street who were able to multiply the incoming reserves via structured financial products and high leverage).  Notice I blame not the pegged exchange rate, but the act of reserve building.  Anyway, now they are imposing price controls to freeze the rising price of oil THAT THEY ARE CAUSING with their expansionist monetary practices. 

The longer the charade goes on, the harder China’s markets and economy are going to fall.  I don’t know when the end comes, but it will come.

Economy Watch:  David Wessel in the WSJ has an interesting piece on the rise of South-South trade.  Chinese and Indian know-how and manufacturing, powered by Middle Eastern energy and African raw materials, but also including Chinese and Indian investment into African countries into wireless carriers and the like.  He suggests that perhaps they don’t need us Northerners anymore.  It’s an exciting new phase of globalization, but last I checked, its the northerners inventing and buying the high tech goods made in China and India, and dollar and euro reserves fuelling China’s preposterous monetary bubble…

Economy Watch:  TCS says that Ben Bernanke, as a student of the Depression, will act aggressively to prevent the credit crunch from turning into a serious downturn.  The trillion dollar question is whether it will work…

Long-term Trend Watch:  Econbrowser discusses the predicitve power of inverted yield curves with respect to recessions, and decides that the jury is still out.  I have noticed that the UK and Australia have had inverted curves for years apparently without effect, and the US just had one that has since steepened.  They also notice that the EU has recently acquired an inverted curve.  My understanding is that inverted curves were more common back in the 19th century, back before central banks were as powerful as they have been in recent times.

It could be that global capital markets are now swamping the central banks in those nations that are the most open to foreign capital flows (i.e. the Anglo-Saxon countries and the EU).  Long-term rates are more anchored and the short part of the curve fluctuates from slight a upward-slope (during a period of accelerating growth) to a slight downward-slope (during a period of slowing growth). 

I have long believed that the Fed’s big monetary mistake in the early 2000’s was not lowering the rate to 1%, which was a necessary risk-management move to fight the threat of deflation (remember how strong the dollar was at that time and how low the price of gold was).  The big mistake was not raising rates faster when the 10-yr spiked to 4.80% in the matter of weeks.  The signal sent by the incredibly steep curve was that the financial markets had loosened and growth would accelerate, but the Fed kept pumping money anyway.  It should have responded to the market signal and raised rates into the low 3% range a bit faster and moved the curve to a moderately postitive slope (provided the long end behaved appropriately).

Right now the signal the market is sending is that the Fed should lower rates to the 4.00%-4.25% range.  If the long bond yield continues to spike up, then it can take away the cuts just as quickly.

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Business Cycle Watch:  The trend is in: the trade deficit is falling.  It is down 2.4% from last month, and trade is now solidly adding to GDP growth (1.3% of 3.8% total GDP growth last quarter).  Imports were down 0.4% and exports were up 0.4%, up for the sixth straight month, to a record.  The odds of avoiding near-term recession continue to rise.

Long-term Trend Watch:  CIBC economist Jeff Rubin predicts $100-a-barrel oil to become the new normal.  The article doesn’t mention Peak Oil by name, but the analysis is the same.  Oil production from traditional sources like Mexico, Kuwait and Russia are declining.  Candadian tar sands oil might temporarily fill the gap, but the long term trend in production is down.  Nuclear and biofuels will be needed to fill the gap.

I have read Hubbert’s Peak by Kenneth Deffeyes about the Peak Oil theory and find the argument pretty compelling.  Read more and decide for yourself.  In the meantime, its a good personal hedge to own some oil stocks.