Follow Up

So I wrote my last post almost 9 months ago, and I wanted to make a short follow up here. Since then, actually within the last 3 months, there has been an increasing amount of believers that we are indeed entering a recession. They have kicked and screamed and held their breath but now it is getting very hard to deny even for the skeptics. Now we are beginning to see slower consumer spending and and tightening credit. The one thing that hasn't happened yet are the higher interest rates and jobless rate has yet to catch up. Though I think there is great likelihood that 08' will probably hold increasing pressure on jobs and we might see the interest rates tick up, although its hard to say. The uncertainty regarding the interest rate has to do mainly with the interference of the fed. Over the last few months they have taken direct intervention in the market by lowering the short term interest rates. I'm not sure I would have made the same call. Of course they are very nervous about a waning economy and I can understand their concern, but in the course of this action they have also weakened the dollar against almost every other currency. While this change in our exchange rate may slightly assist US based exporters by favoring the price of our goods over those made overseas, it has also and will continue to assist inflation. See the one thing that has kept inflation under control in all these years of historically low interest rates are cheap imports. Though now that we are weakening the dollar in relation to the currencies of these other exporting nations, their products will continue to get more expensive. The clearest example we see this is in the price of oil. Oil is very sensitive to the exchange rates. Though beyond oil we have seen inflation in the price of food and other goods as well. So right when we are getting hit by a recession we are going to have to endure price increases into two of our most important consumer staples, food and energy.
The problem here is the Fed policy of trying to avoid economic slow down till the last possible moment. By keeping interest rates down we will only worsen and prolong the downturn in the economy. The most common catch phrase we see these days in the financial news is "credit crunch". It insinuates that there is demand for credit but the supply just isn't there. In the rest of our economy when there is a lack of supply we increase the price to curb the demand and stimulate the future supply. Well the Fed is doing their darndest to see that this doesn't happen. The ultimate result here will be that only the most credit worthy borrowers will be able to receive loans, and ultimately this will catch up with economy and slow it down anyway, much to the dismay of Bernake and his Fed.

The Coming Recession

Let me just start this article by saying that I am not about endorsing gloom and doom. It is rarely wholly accurate and usually not incredibly profitable. All the same I am keenly aware that markets do not go up in straight line. A downturn every so often is inevitable. Yet what amuses me is how much this reality is fought against by very smart and educated financial experts. At the height of the dot com glory days, there were many that insisted that a new paradigm would allow these companies and their stocks to go up for a foreseeable future. What followed were years of market instability. Just a year ago there were many that insisted that the housing market was impenetrable, and would not be deterred by any economic swing. We now see clearly the kinks in the armor. So why are there so many experts that refuse to believe that the next domino will fall?

First let me outline just where we are and the forces that are coming together. Since the collapse of the dot com bubble there were a few pillars that supported the strength of the US economy that allowed it to continue growing. One, as previously mention you had the strength of the housing market. This was brought on by the relief of lower interest rates which allowed Americans to better afford financing on the purchases of new homes and the refinancing of old debt. This ability to refinance allowed many Americans to use the equity on their home like an ATM. They pulled money out of this source of savings and spent it like there was no tomorrow. Second, Mr. Bush in the White House organized a campaign of government spending and tax cuts that pumped money into the economy at the expense of our long term solvency due to the rapid accrual of debt. Many government jobs and government subsidized projects have helped keep Americans employed. The only problem with this is that this hasn’t been funded with cash, rather debt that has largely been raised from the generous government of China and other foreign nations. Their willingness to keep loaning us money has helped keep those interest rates down.

Unfortunately these pillars are crumbling. The Chinese have begun to realized that the 5% interest they have been earning on their US treasury bonds is barely enough to keep them above inflation. They have already stated that they plan on diversifying future investments. They will not continue to support the dollar. This will ultimately lead to either higher inflation or higher interest rates, or perhaps both. If the US government can not sell US bonds to pay their obligations they will have to raise their interest rates till the bonds become desirable. This trend can and may ultimately lead to higher mortgage rates which largely follow the rates of US treasury bills. Higher mortgage rates will continue to shake a housing market that is still filled with speculators that are trying to ride out the current downtrend, many will not have the fortitude and will end up dumping their investments at a loss. Ultimately this will have a dramatic effect on economic activity. Many who have been employed during the housing boom will lose their jobs and not find new ones. To top this all off, because of increasing demand globally for crude oil by developing countries whose people can not afford Toyota Prius hybrids but can afford good old fashioned gas guzzlers, we will see the inflation of energy and the products that depend on that energy to be made.

So lets add this up. Rising interest rates + Falling Dollar + Higher Unemployment + Diminishing Value of Homes = Recession

Yet I am sure that there will be plenty of people out there that claim we are in no imminent danger of seeing a recession. There always are.