Whiplashed into submission

1.3 trillion dollars of market value evaporated into thin air over the week as a result of a flurry of bad news (in an almost coordinated fashion) hitting investors by materially denting their appetite for risk. Disappointing German business confidence figures was followed by weaker than expected U.S. durable goods orders and new home sales, and an unexpected earnings disappointment for Exxon Mobil Corp., triggering a global equity sell off. The prevailing mood was one of pessimism as investors began contemplating the effects of a protracted housing slump and markedly higher borrowing costs on businesses, consumption and ultimately growth. The downward revision in risk premiums and the ensuing flight to quality led to a rally in treasuries, a further widening of credit spreads across the board and the unwinding of carry trades. It also led to several big ticket debt issuance postponements as borrowers began to asses the impact of an increasingly expensive corporate credit market. Volatility, which had been on an uptrend ever since the China related turbulence of late February jumped up again as a result of these events. The gloom is also reflected in the the futures market for the federal funds rate which is at the moment anticipating a quarter point cut by the end of the year with a conviction of 100%.

The fed in a state of benign paralysis?

Reading the tea leaves of Bernanke's recent comments, it seems that we are in for a protracted period of inaction on behalf the fed's target rate (well, technically, its protracted already considering that it has been a year since the fed put an end to its tightening policy). The housing slump shows no end in sight but at the same time there is growing fears that ever so costly food and oil will eventually trigger a jump in inflation expectations. Not that there is anything wrong with sitting tight when it comes to rates. When visibility is poor and when you have two forces pulling in opposite directions as seems to be the case at the moment, doing nothing may very well be the prudent thing to do! Not that we are in the midst of a stagflationary slump considering the relatively strong growth rates and an inflation level that is considered tamed. There has been some criticism of the Fed for prioritizing the core inflation figures at the expense of the headline rate. The original reason behind switching from headline to core was to remove the excess volatility that food and oil contributed to the figures. But things have changed since, with food and oil prices more stable and hence the flak directed towards the fed. The counter argument has been that even with more stable prices, the ultimate measure might still be the core because its only if the core is rising that we know that the rise in oil or food prices have trickled into the rest of the economy. Maybe we should have a compromise, say a dynamically weighted composite of the two measures? Or maybe even invent a new measure? Food for thought, I guess.

A subprime contagion waiting to happen

Markets were once again jolted this week as the sub prime related losses were compounded by the rating agencies decision to downgrade securities backed by this rapidly disintegrating segment of the housing market. The move, albeit a bit late, did send a strong message to the investment community that the size and duration of losses may have been (surprise, surprise) underestimated. This will evidently exacerbate the problem as it means higher lending rates and tighter rules to an already fragile base. The growing risk of contagion triggered a two day stock market sell off, raised treasury bond prices, widened credit spreads across the board and pushed the dollar lower versus other major currencies. Bears clearly had the upper hand over the week, reviving bets that a cut would be the Fed's next move. On a brighter note, trade balance figures for May were spot on with expectations, providing some short term relief for the dollar whilst initial jobless claims came out weaker than expected, signalling continued strength in the economy. Of course, it is common knowledge that economic figures provide a snapshot of the past and are typically subject to revision meaning that we don't really have a full grasp as to the current health of the economy.

Into the abyss

Fears on inflation were revived today with the bank of England's decision to tighten its key rate by a quarter point, sending the pound to a 26 year high versus the dollar on the back of continued strength in the financial services industry and rising home values. This was followed by ECB comments suggesting a bias towards tightening. As if it weren't enough to rock the inflation boat, U.S. service industries and the private jobs report posted stronger than expected results sending treasuries lower.
With the services industries providing a counter balance to manufacturing (turned sour by the sub prime debacle), the impact on employment may be just what is needed to keep household consumption on track. On the other hand we have the so called paradigm shift, in effect putting us in uncharted territory which makes it excessively difficult to predict how things will unfold. The growing interdependency amongst various economies and the increasing complexity and sophistication of financial instruments makes it more and more difficult to grasp the full extent of risks in the market. Warren Buffet's adage of avoiding what can't be understood may be appropriate at this stage.