Treasuries to the rescue...

With hindsight, treasuries have proven a safe bet in the midst of the market turmoil that has left little else intact in its wake. As the subprime tentacles appeared in the most unlikely of places (money market instruments, triple A rated securities) investor appetite for risk took a nosedive. With the volatility index back to normalcy and the days of cheap credit a thing of the past, flight to quality has gained momentum. Fixed income gurus that back in June were convinced that the bull run era that started over two decades ago was reaching its end seem to have gotten it completely wrong. Treasuries posted their best returns last year since 2002 only to be overtaken by TIPS as markets were uncertain whether we were heading into stagflation or just plain stagnation or even recession.
As the U.S. economy showed further signs of deterioration and the risk of dragging the rest of the world into a protracted slowdown grew, inflation worries evaporated prompting the Fed to embark into one of its most aggressive accommodative policies in recent history, cutting the Federal Funds Rate by a spectacular 125 basis points in the span of just a week. If the Fed continues in this direction, it won't be very long before we reach negative real interest rates. This is troublesome as it is difficult to predict the consequences on the economy of having negative rates.

Ceding to panic...

Last night's ad hoc FOMC meeting and the resulting announcement of a whopping 75bp cut in rates(last time such a move took place was back in 1982), bringing the Federal Funds Rate down to 3.5% from 4.25% took everyone by surprise. The global market sell off that began on Monday and continued on to Tuesday, reflecting growing worries that the U.S. economy is slipping into recession, added additional pressure on a Fed that had already been battered for its reluctance to nudge from the inflationary bias, prompting it to take drastic action. The one area that seemed to be unscathed by turmoil so far, namely export demand from the U.S. began to falter as markets around the world entered a correction phase, raising worries of a global slowdown.
What is clear is that by not waiting another week, the Fed seems to have lost control of the situation with its credibility somewhat tainted. The Fed carried out this latest move either because it ceded to market pressures (which in itself is not a bad thing given signs of a rapidly deteriorating environment) and/or because it is acting on information that is not yet out in the open.
What is important now is with regards to the future given that investor perception of the Fed has changed somewhat. This change is likely to have consequences not only on the Fed's behavior going forward but also on how the markets will react to it.

Recession?

There is a growing crowd of doomsayers warning us that the U.S. is already in a recession or that a nasty protracted downturn is just around the corner, but how exactly do we define let alone measure it? According to market consensus, a recession is defined as two consecutive quarters of decline in a country's Gross Domestic Product. Right up to this point, the data we have on the U.S. suggests a slowdown but the problem is that this data is heavily lagged (backward looking) and subject to revisions. That means we will not know if the U.S. is currently in a recession until at least a couple of months from now.
There are other "leading" indicators, however, that can provide precious clues as to the health of the economy. Employment figures such as jobless claims, retail sales, corporate earnings or even the stock market are good examples. The stock market index is particularly interesting because, unlike most other indicators, it is purely forward looking although it can be misleading (such as during periods of bubble formations). A bear market in stocks, defined as an extended period (usually a year) over which prices decline more than 20%, typically occur during periods of economic recession.
So, using these criteria, can we say that the U.S. is in an economic recession? The answer is far from clear. The broad S&P index, for example, is down 9% from its most recent peak (in this regard Japan would be more of a bear candidate than the U.S.). Other indicators such as retail sales, jobless claims and corporate earnings do show weakness, but nothing as serious as with the housing sector which is clearly in recession territory.
With inflation pressure showing signs of easing and further economic deterioration, the balance is tipping towards downside risk on growth rather than the upside risk on prices. No wonder the market is placing a 36% probability for a 75bp cut for the end of the month (up from 0% last week).

Into 2008...

The graph above may bring a bit of nostalgia to those of us that were arcade game buffs back in the 80's but I can assure you this is no sequel to "Tempest". Although blasting vector graphic drawn aliens was a lot of fun at the time, it is also a far cry from today's multi core powered lifelike 3D shading technology.
Getting back to serious stuff, the "radar" (yes, that is what it is known as) graph is a neat way of presenting our global economy expectations for 2008. So what are we saying? Well, we think that there is a strong likelihood of a slowdown (I didn't say a recession!!!) in growth across the globe led by a U.S. downturn (itself a result of the ongoing housing recession and credit crisis).
Our rational is as follows: U.S. consumers are being hit by wealth erosion, on the one end by a steadily shrinking value of their homes and stock market losses and, on the other hand a sharp rise in oil prices making such things as gasoline prices and airline tickets more expensive. We could argue that a quick fix would involve borrowing more (after all, that is what has been powering the recent consumer led expansion in the U.S. and in many other countries). Problem is that lenders are no longer as willing to lend as they did in the past so money is becoming hard to get by (and this goes for businesses too).
We could also argue (like some do) that a marked slowdown in growth would ease the pressure on oil prices, giving the Fed more flexibility with its accommodative policy. Maybe so a decade ago but things have changed dramatically since. The U.S. is having a smaller impact on oil prices mainly because the majority of growth in demand has been coming from China and India (and the consumption levels still remain far below that of developed countries). Combine this with ongoing geopolitical turmoil (most recently with Pakistan) and supply side issues and lower oil prices quickly becomes wishful thinking.
To summarize, the Fed (and many other central banks for that matter) are going to have a tough year ahead but they certainly won't be the only ones who will be navigating in rough waters.

2007 in a nutshell...

2007 turned out to be tumultuous year of transitions as greed got swept away by fear in the midst of a subprime meltdown that marked the abrupt end of an economic boom powered by an era of cheap credit, innovative financing and price stability. Despite numerous warning signs that a crisis was imminent, investors chose to not heed those signs and some ended up paying a very high price.
In this toughened environment of cash shortages, tighter lending standards and commodity led inflation, homebuilders and financials suffered most, the former as a result of a huge and growing backlog of unsold homes and the latter as a result of huge exposure to toxic subprime paper. The consumer discretionary sector was next in line as fear spread to households, prompting consumers to hold back on nonessential purchases, squeezing profit margins already hit by rising raw material prices.
A rapidly deteriorating economic environment prompted central banks to intervene on several occasions, injecting much needed liquidity into the system. The calming effect was temporary, however, as the root problem was not being addressed.
As signs and anticipation of a marked economic slowdown hit the U.S. the decoupling theme gained importance as the rest of the world did not show any signs of weakness. Emerging markets in particular, benefiting from stricter monetary and fiscal discipline, large foreign reserves, foreign direct investments and the formation of a distinct middle class, seemed somewhat more resilient and less dependent on the gyrations of the U.S. business cycle.
The current economic crisis, like many before it did produce opportunities. The lack of transparency in subprime related mortgage backed securities and growing fear of inflation and that the market was heading for a recession prompted investors to seek the safety of treasuries and inflation protected securities, sparking a huge rally. On the equity side, sectors such as healthcare, consumer staples and information technologies also thrived for different reasons.
On the currency front, the dollar's value kept eroding, hit by the economic deterioration and anticipation of greater divergence in interest rate differentials.