T-Waves

[Tetres]

What may loom ahead in my opinion is a 85% chance we enter a double-dip recession

Trillions in stock-market losses and sagging consumer confidence threaten to repeat a pattern last seen in 1981. Wall Street's relentless slide, coupled with a loss of confidence by big business, is now threatening to create a rare phenomenon in United States history called the double-dip recession. While the economy is still at a very modest pace at the moment, a case can easily be made that the loss of trillions of dollars in stock value and a series of corporate scandals is creating such pessimism that it alone could push the US back into recession by the end of the year.

What concerns me is that that further monetary easing by Sir Alan and his band of merry men would most likely delay a necessary, yet painful, purging of excesses from the bubble years. Personal saving is still far too low, and corporate and household debt is at extreme levels. Excess capacity still needs to be culled from the corporate root cellars. Recessions are a natural course of economic cycles, that the drive this corrective effect. Yet even after the recent pro forma downward revisions to GDP, last year's recession was still one of the mildest on record too mild to do much about the excesses that are facing corporate America.

Here lies the dilemma. Lower interest rates may now be vital to lessen the deflationary risks, (even possible stagflation) including the risk that deflation would further increase the debt burden of households and companies. Yet easy money has encouraged people to borrow more and has thus delayed the inevitable adjustment in their households' balance sheets. The role of monetary policy is to ease such adjustments, not to postpone them. As a result, an overhang of debt could act as a drag on growth for several years to come.

The Federal Reserve is not yet convinced that America's economy is heading for a double-dip recession. At its recent policy meeting on August 13th, the central bank decided to keep its federal-funds rate unchanged, at a 40-year low of 1.75%. Still, it signaled a readiness to cut rates should the economy look like it was going to weaken significantly further. GDP growth in the second quarter slowed to only 1.1% at an annual rate. In July, the purchasing managers' indices of activity in both manufacturing and services fell sharply; total hours worked also declined. Retail sales rose by a robust 1.2% in July, yet this was due mainly to car firms offering interest-free loans. Not counting cars and petrol, retail sales were flat. And as we saw consumer confidence fell sharply. The slide in confidence partly reflects the slump in equities. Share prices have picked up a little from their late-July lows, yet the stock market is still worth about $7.8 trillion less than at its peak in early 2000. The loss has partly been offset by a rise in house prices, but the latest figures suggest that the housing market may now be cooling off, as we have seen two months of contractions. For the third year in a row, households are likely to see their net wealth shrink. Savings rates are still historically low, so unless share prices rebound, households will probably have to start saving more and spending less, something the American public is not generally accustomed too.

Another cause for concern is tighter conditions for corporate credit. Not only have banks tightened their lending standards; borrowing in the corporate-bond market has also got much tougher. Interest-rate spreads (the difference between the yield on corporate and Treasury bonds) have widened significantly and as a result, many firms face a higher cost of capital, despite the fall in the yields on government bonds. A crunch caused by firms finding it hard to refinance their debts would most likely result in another round of cost cutting.

These are all reasons to expect that Sir Greenspan and his band of merry followers will most likely reduce interest rates again, possibly at their next meeting on September 24th. Perhaps the strongest reason, though, is that if the economy does slip back into recession, it will be at a point of very low inflation. America's GDP deflator rose by just 1% in the year to the second quarter. Another slump in output would nudge the economy dangerously close to deflation.

Now the FED is also hoping that Plunging Interest Rates will impact and potentially save the economy!! By signaling that it was worried about the economy but felt interest rates were sufficiently low to keep the recovery on track, the Fed unleashed a rally in the U.S. Treasuries market that has sent benchmark yields plunging below 4.00% at one point levels not seen since 1963. Consumers, businesses and state governments are all benefiting from the super-low yields that have sparked a big wave of home refinancings and slashed baseline borrowing costs freeing up cash for a struggling economy in need of a shot of adrenaline.

Sir Greenspan and his band of merry band of followers are delighted to see this course. The 1.4% point drop in 10-year Treasury yields during the past five months has an even larger impact on consumers through lower mortgage rates than a cut in the official federal funds rate ever could. Currently nearly 72% of the $8.8 trillion in debt households have is in the form of mortgages.

With the historically low market rates dragging down mortgage rates to levels not seen in decades, Americans have lined up in record numbers to take out mortgages for home purchases or refinance. Now if the American populace was prudent this allows expensive credit card debt to be paid off, fattens checkbooks and, as a result, helps boost consumer spending. With home values rising roughly 15-17% in the past year, homeowners have been able to tap into a growing source of wealth.

Among the forces that have helped to drive the 10-year Treasury note's yield down to historic lows below 4% was the long-awaited arrival of a huge wave of hedging activity from mortgage market participants. Heavy buying from mortgage investors seeking to hedge against negative convexity risks in their portfolio was seen in both Treasury and agency markets. The buying took place a day after the Federal Reserve decided to keep short- term target rate at 1.75% while acknowledging that the downside risks to the economy are outweighing its potential upside. That stance was interpreted by some as a signal to unwind so-called "curve steepening" trades in the Treasurys market, moving out of short-dated Treasuries into longer-dated maturities thus driving their yields lower. The benchmark 10-year Treasury notes has seen a 39-year low, as it moved to a new low of 3.96% last week.

Thirty-year mortgage rates are expected to slide to a new record low this week after falling to 6.13% last week, opening up the opportunity to refinance for millions of Americans with old mortgages at rates as high as 7.5% who haven't done so yet. Last year a record 7 million homeowners refinanced their mortgages, cashing in on about $110 billion of equity wealth in the process. With the sharp drop in rates likely to mean even more refinancings this year. The powerful support from consumers cashing in on their rising home equity values and taking advantage of falling mortgage rates to buy homes is a new twist compared with prior periods of recession and recovery. This is what the Fed is banking on to power the continued consumer spending.

Companies will also reap the rewards of historically low market yields by borrowing more cheaply. And after roughly two months when the stock market's sharp slide nearly shut down capital markets and jacked up borrowing costs, new debt issues are beginning to emerge. Even if credit spreads widen somewhat, the fact that it's off a lower number still gives corporations some absolute rate relief. State and local governments have also seized on the drop in yields to issue billions in long-term debt that has saved them money by replacing expensive, older debt and going into deficit borrowing at low rates. The state and local borrowing has also come to fund new projects such as bridges and courthouses, maintaining spending that helps the economy even as budgets are pinched by falling revenue. Long-term municipal debt issuance is up 17% so far this year to $200 billion and is expected to reach a record that surpasses the $292 billion sold in 1993.

Sir Greenspan may be backed into a corner. Just some food for thought


Best of Luck
Steve
http://twaves.com