Will The Real Hangover Stand Up?

Posted by urbandigs

Tue Oct 16th, 2007 12:19 PM

A: For readers of urbandigs, you know my cravings for macro economics and my interest of understanding how markets relate to each other for future forecasting / investing. It was clear that equities were drunk on rate cuts, as I posted last week, and I think the street is yet to adapt fully to a world of credit restrictions, solvency issues, global inflation and higher rates. The first credit blip was an 'awakening' of sorts, and for those that think it's completely over, well, stop hitting the snooze button!

First, I want to briefly talk about what is going on in the ABX markets, AGAIN! Perhaps this is one of a few reasons why stocks are retreating from record highs. Thanks to Calculated Risk, we can see that the credit markets are again having difficulties finding any bids! Look at the charts on the right, provided in the post, "ABX Indices: Look Out Below". These markets collapsed in February, when the Yen/Carry trade issue popped up, and then again in July, right before the credit crunch awakening hit. Is the latest collapse another indication of distress in the credit markets? I've mentioned before that the credit mess is NOT OVER! We are yet to see the full dragging effects of the credit turmoil in corporate earnings and the side effect to investors and the consumer. This is why the fed aggressively cut the funds rate by 1/2 point, as a lagging action for the future hit! You remember my initial reaction when they took this action, where I stated:

With such a move, I question how bad this credit mess really is on effecting the US economy and continuing the housing downturn!
Is the recent selloff in ABX markets a sign that foreclosures and defaults are a problem again? Are we going to get another round of credit worries? After all the write-downs by corporations, will we find out that MORE is yet to come as earnings are hit in future quarters? These are the questions that come to my mind when I see what is going on in the credit markets! But don't take my word for it.

Housing Derivatives Blog has a great explanation of the ABX markets:
The ABX Index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses from those investments. Likewise, an increase in the ABX Index signifies investor sentiment looking for subprime mortgage holdings to perform better as investments. This week, all of the BBB- tranches settled on lifetime lows. Three of the four BBB tranches settled on life-of-contract lows.
Conclusions? Something is going on under the surface that is yet to hit! With stocks just off record highs, and the inflation pipeline bursting at the seams, what is the fed to do about it? First off, know that the action taken by the fed on Sept. 18th was preventative and has not yet funneled through the economic system. It was an insurance policy taken out by the federal reserve board of governors in case the fallout from the credit squeeze is worse than expected! They don't know how bad it will be yet! But we do know what is limiting their actions: future inflation and price stability!

That is what makes this situation so unique. Oil is trading at record highs, near $88/barrel, on geo-political tensions and supply concerns. Out of that, I would say add in about $10-15/barrel of speculative bets on momentum. Nevertheless, it's a concern at these levels for future inflation and slower growth. In my post, "Hot Numbers & The Misleading Core", I discussed how the headline PPI # came in high, but when you strip out food & energy, came in moderate. Well, we are YET to see the full effect of higher food & energy prices on US economic data! Hard to argue that inflation will moderate in the years to come. The US economy is a mature and resilient monster, and as such, may not suffer as hard as some faster growers internationally; but the story is yet to be finished and we must focus on the last few chapters very carefully to see how that effects monetary policy, the US economy, jobs, and the credit markets. My opinion? I think we are headed for an era of tougher credit, solvency issues, higher rates, and global inflation. How the US economy handles this compared to global economies is what I have no clue on. To put it another way, if the party ends at 2AM, I think it is about midnight right now and I just don't know how bad or how long the hangover will last.

Here are some words from Ben Bernanke from the NY Economic Club:

* "It remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions...Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time and we may well see some setbacks"

* "The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year."

* "the FOMC was prepared to reverse the policy easing if inflation pressures proved somewhat stronger than expected."

I expect monetary policy easing to reverse by early-mid 2008, as inflation data finally shows the effects of higher energy, higher commodities prices, higher food prices, and side effects of global inflation hitting home: read Barry Ritholtz's "Exporting Inflation from China" post and Time.com's article "China's next Big Export: Inflation" for a more detailed analysis on this topic.