Jon
Preferred Member
Cash: $ 50.02
Posts: 193
Joined: 13 Apr 2005
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| Changing the economy's song and dance--again |
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This past week the crowd started changing its tune with respect to the economy . . . again. For most of the past year, the mindset was anything slowing the Fed down was a positive. Sure there was some backwash from time to time as investors worried the economy might slow too much, but overall the party line in equities was you had to get the Fed out of the way first. That is quite true; given the Fed’s history you want it out of the way as soon as possible to avoid overkill. Of course, history also shows the Fed rarely, rarely, rarely (and we mean rarely) ever stops slowing the economy before it does real damage. It doesn’t want to hurt it, but as in ‘Of Mice and Men,’ it has no concept of its strength over the economy and kills off prosperity when it just means to help. Thus it is almost a death wish investors hold: you want to Fed out of the way but you know if it is that likely means interim pain. Maybe not a death wish, maybe just some form of sadomasochism, knowing you have to endure the pain to get to the pleasure.
As in 2000, views of the economy’s ability to continue its expansion remain overall positive in most cases to downright giddy in some. There is the other end of the spectrum warning of a severe problem what with housing cratering and high consumer debt, but just as there are always cheerleaders who see no evil (remember Joe Battipaglia in 2000?), there are gloom and doomers who see only evil. Housing is in a fast fall now. The evidence is very clear in all aspects of the sector, but one of the most telling is the continued decline even as interest rates are in a dramatic decline. If low rates cannot spur buying, that is a sign of a slumping sector.
Thursday the overall sanguine view of the economy was rocked some when the Philly Fed, a very volatile regional manufacturing report anyway, plummeted from 18.5 to -0.4. The swing was so dramatic it almost screams aberration. Still it gave stock investors a dose of economic queasiness and helped spur a reversal of the Wednesday break higher. Stocks have not broken lower by any means. The patterns developing since April and May are still holding, and one of the best indicators of economic slowing is the market. It peaked in early 2000 and sold hard, recovered to a July peak, but then topped again in September and it was all over but the crying.
That is one reason we are watching this test of the May highs by SP500 and DJ30 so closely. This is the fifth base since the October 2002 bottom (on NASDAQ; fourth on DJ30), and while that does not mark in stone a top, it is an indication a bigger test may be near. There are already signs of economic slowing, more than in 2000 when the Fed stopped that hiking campaign. Thus you could argue the Fed hiked further into those slowdown than it did in 2000, and that is not great news. Of course the Fed has been more mature in its handling of money supply this time around, steadily bringing it down but not turning it off cold turkey as did the Greenspan Fed. It yo-yoed money supply up and down, pouring cash in ahead of Y2K even as it tightened rates to slow the economy, then yanked it out 100% in March 2000, put banks on restriction, and hit the economy with a 50BP hike in May. Not good management as the results showed. That doesn’t change the fact, however, that we had signs of slowing even as this Fed continued hiking, and the slowing is only picking up speed. Maybe the bond market is right in predicting rate cuts by year end. That remains to be seen. Stocks have not cracked yet.
Some say bonds are telling a different story this time, but they miss the big picture.
Ah the bond market. Its predictive powers are extolled and dismissed, at times in the same breath. Greenspan was out in 2005 saying the flattened yield curve did not mean anything because it was due, in some part, to foreign buyers of treasuries, recycling all of those petro-dollars, etc. He could never say how much was due to that, however, something he did admit but no one seemed to own up to. They preferred to focus on the foreign buying as the sole reason for the decline in yields.
Bernanke picked up on that theme, but some scholars say he doesn’t really believe it that much, but was in a position of carrying on the Greenspan mantra at the first part of his tenure. Right now with commodities tanking and emerging markets not emerging so fast, a lot of that money that was swinging for the fences in pork bellies and Thai coffee houses has returned stateside, looking for more safety. That, the non-bond believers say, shows the rally in bonds and the drop in yields (and the inversion) is not your father’s flat curve, i.e. is not predictive of an economic slowdown.
Sounds pretty logical; that money has to find a home somewhere when those other markets are not so favorable anymore. But you have to ask WHY is the money going to safe havens? If economic times were going to remain good overseas in these markets the money would stay there. If commodities prices were going to move higher due to demand, they would be soaking up that money. Instead there was a bubble, a blow off top in commodities and emerging markets, and they are now correcting. The money is moving into US stocks and bonds, looking for safety in US securities. That happens in every economic slowdown; money seeks safety. When it does it comes in to US treasuries and that drives down yields, just as in EVERY economic slowdown. Thus this influx of capital that drives US rates lower is a natural part of every economic slowing, and is not an indication of the bond market’s lack of predictive power. It is PART of that predictive power as money anticipates slowing and seeks safer homes.
Further it is not all massive buying as you would assume from the financial stations. The most recent data from July shows net foreign purchases down 50%. With investment taking a dip, you cannot explain lower bond yields on vast quantities of foreign money pouring into the system. It is having its effect as usual, but it is not the only power at work. Thus it is wrong to just say the bond curve doesn’t mean much anymore, just as it is wrong to say the Fed got it right this time. Both remain to be seen, but given history, it is a really aggressive bet that bonds are totally wrong and the Fed is going to deliver one of its rare soft landings. If that is the case, I am buying one lotto ticket this weekend and I expect to win.
As I said, it remains to be seen who is right. Stocks are still moving higher while bond yields are inverted and moving lower. Indeed, this past week the inversion between the 2 year and the 10 year hit its highest (10BP) since March before correcting back to close the week at 7 BP (4.67% on the 2 year versus 4.60% on the 10 year). A modest inversion but a pesky one that won’t go away. For the week, however, bond yields fell a whopping 20BP, the most since April 2005. All the while the spread between the Fed Funds rate (5.25%) set by the Fed widens, indicating the bond market is predicting much slower times than the Fed (after this Wednesday meeting its statement said it was still leaning toward an inflationary bias). As noted above, the bond market anticipates Fed cuts by year end. For now stocks are holding up nicely, but with the Dow and SP500 coming off tests of the May highs after a long run higher it is time to be vigilant and watch how the stock market responds to the pullback from those May highs.
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