The Slope of a Slope
Wall Street loves the second derivative, or the slope of a slope. When the speed, with which our financial system is disintegrating diminishes, then we must be getting better, right? Wrong. We are still disintegrating. The speed at which this is happening is what matters these days. You see, last year we blew up about one bank per year worldwide. Last week it looked like we were blowing up one bank per week in the US alone and that by the end of December we would be headed for one bank per day firmly on our way to reach our cruising speed of one bank per hour by the end of January. It now looks that we are not going to reach the cruising speed until the end of March. We are still accelerating, mind you, just not as much as feared. Of course, we would eventually run out of banks to blow up. Whether that means that the world would be a better place or not is debatable. In any event, Wall Street looked at the decreasing speed of pain intensification as something good until the Fed came along at 2:15 pm on Tuesday, announcing that it was going to lower the Fed Funds rate by 0.25%, thereby reducing the speed of interest rate cuts. After that traders sold stocks and bought bonds, believing the Fed was not willing to ease key interest rates enough to relieve credit market pressures. In other words the acceleration of easing moves was not enough to offset the acceleration of credit market pressures. The result was as one might suspect an increase in volatility. To be sure, Bernanke is between a rock and a hard place. On one hand, the November employment report reflects continued slow job growth in the U.S., slow enough to elicit continued interest rate cuts. On the other hand, markets had to digest a tide of ugly inflation data, which under ordinary circumstances would have caused the Fed to increase rates, not decrease them. The consumer price index rose a bigger-than-expected 0.8% in November, pushed higher by rising energy prices. The core CPI climbed 0.3% in the month, slightly more than expectations as well, raising fears that energy inflation finally permeated the entire economy.
Even though the Federal Reserve disappointed the markets Tuesday by offering up a meek policy decision that seemed both behind the curve and mired in inconsistency, the two charts above explain at least partially, why the Fed showed some restraint. The economy might have needed a decisive signal of a 0.50% cut, but the inflation data (above) prevented it. The first chart shows us the impact of rising energy and food prices. They pushed the index beyond 4% for the first time since 2005. But even though the red line (1st derivative) looks bad, the green line (2nd derivative) the slope of the slope is already turning down. It seems to me that the acceleration part of the CPI is already behind us, even though the rising part itself might continue for a month or two longer. It is different, however, for the Core CPI, which was reported on Friday. Here you see that the rate of change just recently started to re-accelerate and that is probably what keeps many Fed Governors up at night. Bonds reacted by falling to yield more than 4.25% for the first time since the beginning of November. Just two weeks ago, bond yields had fallen below 3.90% as panic gripped Wall Street. Now inflation shoved bonds the other way. The dollar followed rising US yields by rising also. ... Did you get that? The Dollar rose despite the seemingly intractable twin problems of falling economic activity and rising inflation that the Fed is faced with! The dollar will likely continue to rise, as predicted here and here. Stagflation was the word most often used to describe Bernanke's problem and while international news agencies reported breathlessly about the sick economy in this country, $300 Billion of looming writedowns and a defaulting banking system, the dollar proceeded to enjoy its biggest one day rise in recent memory. There were solid reasons for this jump and I would like to outline those. Retail sales rose twice the amount that the pessimistic consensus had expected in November, and, excluding autos, retail sales jumped 1.8% rather than the 0.6% consensus forecast. And the October data were revised higher. The real U.S. trade deficit was also a bit smaller than expected. Most analysts forecast GDP growth for the first and 2nd quarters of 2008 to hover around 1%. But when assessing currency markets, they need to be understood not only in terms of what is happening domestically but also how they compare with other countries. The slowdown that the U.S. is experiencing now will still produce a growth rate of which much of Europe and Japan can only dream. The dollar is discounting an improving economic future some six months out. Look for yourself:
Dollar Index (6 currencies) Daily Dollar Index (6 currencies) Monthly
Without anybody noticing and right under our noses, the dollar put in at least a trading bottom. While everybody was fussing about credit markets, write offs, financial stability and mortgages, the dollar index and foreign investors prepared for a better future. They acted while everybody was focusing on domestic problems. The combination of a weak U.S. dollar and relatively cheap U.S. assets has encouraged direct investment and increased use of the U.S. for sourcing and production by foreign companies. Unit labor costs in the U.S. look downright attractive when converted to euros or sterling. In addition, economic weakness is creeping into the European economy as well. Auto sales in Europe have declined in two of the last three months. The sub-prime credit market turmoil has gripped Europe as well. The IMF said in it's Regional Economic Outlook for Europe: "Central banks will need to continue to be ready to assist financial markets." In other words, the likelihood that European interest rates must come down further has risen considerably and these benefits the dollar as the likelihood that interest rates must come down further in the U.S. has diminished slightly. A Fed that is being handicapped by ugly inflation readings in its fight against recession coupled with a strong Euro-Block that is slowing down as we speak should lead to rising interest rate differentials six months down the road. Again, it is the speed that counts. If the Fed has to decelerate interest rate cuts while Europe has to accelerate them, then that slope of a slope favors the dollar. Merry Christmas!
"Sometimes a majority simply means that all the fools are on the same side."