Short Term Positives, Long Term Questions

Good Evening: The forces of poor economic fundamentals clashed again today with government programs created to address them. It’s the American way to focus on which side “won”, but these battles usually result only in “relative” winners and losers. Keeping this disclaimer in mind, it was owners of Treasurys, mortgages, and equities that were ahead at day’s end, while those who hold dollars and commodities were less well off. The mere fact that stocks held on to their huge gains since Friday has to be viewed as a short term positive, since ten weeks have passed since the last time Mr. Market smiled after three straight closing bells. The contempt many will feel about paying higher taxes to pay for cleaning up this mess will be around for a long time, but PIMCO’s Paul McCulley makes a decent case why we should just swallow this medicine, create a better financial system, and move on.

While market participants were sifting through a Q3 GDP report revealing that growth slipped to -0.5% last quarter, the Fed announced two new programs to help restart lending. The details of these plans are described in articles below, as well as in another fine piece by Merrill Lynch, but the reaction in the fixed income markets was one of unequivocal support. Treasurys and mortgages were both very well bid, TIPS were rediscovered by fixed income investors, and even swap spreads fell in the wake of the Fed’s latest plan. Aside from still frigid conditions in the credit markets, perhaps the big reason why the Fed feels these latest actions are warranted was another large drop in the Case-Shiller home price index (see Merrill’s take below). Falling a record 17.4% nationwide, the index also indicated that home prices fell in every one of the 20 major U.S. cities tracked by Case-Shiller. The large fall in mortgage rates today is most definitely a welcome sight, but don’t expect home prices to reflate any time soon. As Merrill points out, there is still a ways to go before prices revert back to mean levels.

Stock opened higher in response to the Fed’s announcement, with the major averages up between 1% and 2% during the first hour of trading. A bout of profit taking then set in, a sell off honed by so many failed rally attempts since Labor Day. Knowing that stocks had been up for two days straight, and armed with the knowledge that the major indexes hadn’t been up for three days in a row since September 10-12, short sellers likely also attempted to push stock prices lower. They succeeded for a while during the middle of the day, but equities mounted a comeback during the session’s final two hours. The NASDAQ did finish with a small loss, but the rest of the indexes finished in the green, with the Dow Transports (+2.8%) leading the way higher. As mentioned above, Treasurys rallied and yields fell between 8 and 22 basis points. The dollar was sacked for a 1.5% loss, but the setback in the greenback didn’t help commodity prices. Despite a fourth straight up day for gold, energy prices fell and paced the 2.3% drop in the CRB index.

In a previous comment, I likened the struggle between the weakness in the capital markets and our government’s attempts to revive them as a cage match between Mr. Market and Uncle Sam. I felt at the time that Mr. Market had the upper hand, but I must say I like Paul McCulley’s imagery better than my own. He describes a match between “the visible fist of government” and the “invisible hand” made famous by Adam Smith. Cheering for one side against the other misses the point, in Mr. McCulley’s opinion. He reminds us all that what we’ve thought is a sharp line between “private goods” (e.g. stocks and bonds, or his local fishing store) and public goods (e.g. defense, or the department of motor vehicles) is actually a blurry one when it comes to our financial system.

Mr. McCulley admits that our overly leveraged system has broken down and he uses arguments from Lord Keynes to show why. “The paradox of deleveraging” posits that it is all but impossible for a debt-laden, private system like ours to delever all at once without imploding. His solution is to let Uncle Sam expand his balance sheet while private ones shrink, calling the whole process necessary, perhaps even a “public good” in and of itself. I don’t buy into all his reasoning, especially since there may be large consequences down the road with all this massive government involvement. But I do agree that if we can avoid a systemic meltdown and create a better set of rules to govern the deposit-based financial system on the other side of this turmoil, then we should all be able to live with the outcome. Let’s hope he’s right and that during the next down cycle we find a way to prevent financial institutions from levering up to the point of endangering our whole system. Today’s late rally in equities may be a short term positive, but I’m going to hold some gold and some mining stocks just in case the long term shift to a new paradigm isn’t as smooth as Mr. McCulley hopes.

— Jack McHugh

~~~~

Sources:

Fed Commits $800 Billion More to Unfreeze Lending
http://www.bloomberg.com/apps/news?pid=20601087&sid=ai_aErzotzx8&

U.S. Mortgage Rates Fall on $600 Billion Fed Plan
http://www.bloomberg.com/apps/news?pid=20601087&sid=a2AwJzGlKwIM&

Treasuries Rally as Fed’s Move to Buy Mortgages Prompts Hedging
http://www.bloomberg.com/apps/news?pid=20602007&sid=asWB1_IdSNCY&

U.S. Economy: Home-Price Drop Accelerates, GDP Falls
http://www.bloomberg.com/apps/news?pid=20601087&sid=agcSNwaOYvxE&

The Paradox of Deleveraging Will Be Broken
by Paul McCulley, PIMCO
http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/Global+Central+Bank+Focus+11-08+McCulley+Paradox+of+Deleveraging+Will+Be+Broken.htm

Download Your Report: REALly big home price decline.pdf

Download Your Report: Still following the 2002 playb.pdf

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