A READ OF THE TEA LEAVES
By Stanley C. Clayton
January 12, 2010
Economic Tea Leaves
There has been more to the administration's "green shoots" than it appeared to me in May 09, but not much. The economy continues to struggle and appears now to be close to a standstill: gains here about offset losses there. Where does it go from here and how does it get there? Let's see what we can figure out.
Bernanke (Fed Reserve) has been in the news for a while cautioning Congress that they must hold down spending as he can only do so much in creating the money to pay for deficit spending. He has given the President the same message, and he is telling the rest of us that it may be necessary to raise interest rates and to stop monetizing debt. While this could be nothing more than "jawboning", I suspect it is more likely keeping his options open in case he needs to make a significant change in Federal Reserve actions. It was not that long ago when the media reported Bernanke was saying that he can create unlimited sums of money, and that the Federal Reserve would buy as many Treasury bonds as needed. Something has rattled his cage. He has not said why, as far as I know, but it could well be in response to concerns such as those listed in November Tea Leaves. They bear repeating here.
1. Governments and investors around the world are increasingly worried about the expanding supply of dollars decreasing the value of the dollar which reduces the value of the trillions they have invested in U.S. bonds and such. 2. When bonds go down, interest rates are pushed up which runs up the cost of servicing the U.S. debt and slows the U.S. economy. 3. This is forcing other countries to work hard to replace the dollar as the sole currency for international trade settlements.We are likely to see more comments in the media like the following:
"At some point, if the U.S. does not address proactively its deficit outlook and its debt outlook, there will be a financial-market revolt," says Roger Altman, chairman of investment firm Evercore Partners and an assistant Treasury secretary in the late 1970s. Mr. Altman says that while he doesn't expect such a revolt to happen in the next couple years, "if we let this go past 2012, we're playing with fire." Wall Street Journal January 5,2010 by Mark Whitehouse.And like this:
Bond guru Bill Gross at Pimco in Newport Beach this week has ramped up his warnings to the Obama administration and the Federal Reserve about the perils of unfettered government borrowing. In an interview in Time magazine on Tuesday, Gross suggested that Pimco, which manages nearly $1 trillion in mostly fixed-income assets, now feels more comfortable owning German government debt than U.S. Treasury debt... . Los Angeles Times, Bill Gross puts U.S. on notice about debt binge, by Tom Petruno, January 6, 2010.
As we move forward in time, the Federal Reserve will come under increasing pressure for restraint. But this comes at a time of need for further bailouts in one form or another. December Tea Leaves discussed the current onset of another giant wave of mortgage resets at least as large as we experienced in 2007 though 2008. This time, however, commercial real estate mortgages also are in trouble, as has been widely reported in the media, adding further to the troubles. These events could hardly come at a worse time for the Federal Reserve, because they have made the natives restless on planet earth. The following quote relates to this.
“New York, December 29, 2009 – Data through October 2009, released today by Standard & Poor’s for its S&P/Case-Shiller1 Home Price Indices... . The turn-around in home prices seen in the Spring and Summer has faded with only seven of the 20 cities seeing month-to-month gains, although all 20 continue to show improvements on a year-over-year basis. All in all, this report should be described as flat.” says David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s. “Coming after a series of solid gains, these data are likely to spark worries that home prices are about to take a second dip. Before jumping to conclusions, recognize that the one time that happened at the beginning of the 1980s, Fed policy saw dramatic reversals, which is very different from the stable and consistent Fed policy we have today. Further, sales of existing homes – those included in the S&P/Case-Shiller Home Price Indices – have been very strong in recent months, working off the inventories of houses for sale. At the same time, housing starts remain weak, fears that the market will be swamped by a wave of foreclosures are heard and government programs aimed at the housing market will expire in the first half of 2010. [December 29 www.scribd.com/doc/24592453/S-P-Case-Shiller-Home-Price-October-Results]
1 Case-Shiller® and Case-Shiller Indexes® are registered trademarks of Fiserv, Inc.
Of particular interest is the remark about fears the housing market will we swamped by a wave of foreclosures. Recall back to the Credit Suisse chart of mortgages in the December 2009 Tea Leaves. This chart quantifies the size of the foreclosure wave. It is of tsunami proportions like the one in 2007-8 that caused so much economic and social destruction.
This time around, however, there are some differences that may prove to be worth noting. The Federal Reserve has bought over one trillion dollars of toxic mortgages from banks and other lending institutions such as Fanny Mae and Freddie Mac, yet large amounts of this toxic debt appears to remain on the books of these institutions. Banks usually like to tell the world how well capitalized they are, but have you heard much of this lately? As many of these toxic mortgages blow up (borrowers unable to maintain payments), mortgage backed securities (known as MBSs) containing these toxic mortgages will suffer as well. Should this come to pass, it will be like land mines going off all over the world, because this is where these MBSs have been sold.
That is only one side of the problem. The another is that if foreclosures sky rocket again, this will force vast numbers of people out of their homes. This would greatly increase the glut of homes on the U.S. market driving home prices yet lower. Just what we need. Yet another side is the toll it would take is not only would family economies involved, but the psyche of each of us as we real from its direct and indirect impacts. Accompanying this would be a variety of social changes some of which would have significant implications for our entire society as well as for the stock market. This would not be merely a double dip for stocks, but a "slam to the mat" for our entire social system. As the time draws closer and if this event moves from a probability to more of a certainty, Tea Leaves will cover this in some detail.
It is still possible there may be an alternate future where somehow we muddle through without a major market meltdown. As this plays out, there will be decisions yet to be finalized or implemented that could influence the outcome. For example, the Fed may choose to risk yet more by extending the loose money policy, or other countries may have substantial difficulty formulating just how they will seek to get out from under the U.S. dollar influence. This is a fluid situation well beyond the usual.
This is a good place to remind the reader that I do not know the future. I seek to marshal what I sense are the relevant facts, reason them through, and speculate on what seems likely to happen. While I am a scientist, this is not science. It is forecasting, pure and simple, warts and all, imperfect even at its finest moment.
Stock Market Tea Leaves
As you have likely surmised, my sense is the stock market may yet have a serious tumble: we may get to play 2007-2008 all over again, or if not, be in the doldrums until everyone is ready to scream. Should either develop, the up side is that the Fed has prepared banks and other lenders as best it can - a potentially positive influence. The down side is the Fed may well be reaching its practical outer limits, as we have discussed, and be forced to restrict its actions - a potentially negative influence. As discussed in October Tea Leaves (see the archive located page right), the tendency of investors likely will be to continue buying as long as the Fed continues flood the world with dollars. Buying is likely to be tempered if the economy shows signs of faltering after the effects of Christmas have passed, for example, or the home foreclosure rate spikes up again, or the rise of widespread commercial real estate troubles, or all of these. This reminds me of the saying "may you live in interesting times" and why it is considered a curse.
What should you invest in and what should you avoid? That is up to you as Tea Leaves is not an investment advisory service. I consider this an educational adventure. If you have taken the trouble to reason this through with me, and integrate it with your other knowledge, you may find it useful in investing. It certainly is useful to me, as it forces me to think this through more systematically and completely than I might otherwise. Besides, thinking is a joy in itself - almost as good as being able to laugh all the way to the bank!
