When Disasters Become Commonplace by Josh Sidman

Josh

by Josh Sidman
Dandelion Salad
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Josh’s Blog Post

Nov. 1, 2007

Did you know that the Federal Reserve pumped $41 billion into the US financial system today? Did you also know that this is the largest single-day infusion since September 19th, 2001, when the Fed injected $50 billion following the attacks on September 11th?

The amazing thing is that nothing happened today, yet the Fed needed to pump nearly as much money into the financial system as it did right after the worst terrorist attacks this country has ever seen. This is a startling commentary on the current state of the US economy. As I have observed in previous articles, our financial system is coming more and more to resemble a drug addict in the last stages before hitting rock-bottom – i.e. the stage at which ever increasing amounts of drugs are required just to avert a total collapse. The fact that a cash infusion of similar size to what was required in the immediate aftermath of our country’s greatest disaster is now a commonplace, daily occurrence indicates just how far gone we really are. The image that keeps coming to mind for me is from the Road Runner cartoons of my childhood, in which Wily Coyote runs off the edge of a cliff but doesn’t actually fall until he looks down and notices where he’s at. In a similar manner, the US financial markets continue to chug along with only minor hiccups, still safe in blissful ignorance of the fact that the ground beneath its feet has long since disappeared.

Yesterday the Fed cut rates yet again, and the market predictably staged an anemic rally, only to be followed today by a sharp sell-off. One thing is certain in financial matters – no matter how hard you try to ignore the cold, hard facts, debts don’t just go away (in fact, they grow), and you can’t get something for nothing. Try as we might to ignore these realities, there comes a point at which any remedial measures produce less and less positive results. And, in addition, the measures themselves entail significant costs of their own. After all, where do you think the $41 billion came from? In a monetary system where a rapidly increasing supply of dollars must compete for a stagnant (or slowly increasing) supply of real goods and services, the consequences are obvious. Prices must rise – i.e. inflation. And, no matter how the financial authorities fudge their numbers in order to avoid admitting that inflation is actually occurring (e.g. with the change from use of CPI to PCE as a measure of “core-inflation”, thereby conveniently removing food and energy prices from the official measure of inflation – after all, who needs food, gasoline, and heating oil?), it is becoming increasingly obvious to the average American that the official story just doesn’t add up. After all, when you’ve seen gas prices double, housing costs double, and medical expenses skyrocket, who really cares that the government tells us inflation is under control?

When Wily Coyote will finally look down and realize his plight is anybody’s guess. The ability of the US financial markets to persistently ignore reality has been remarkable, but that does nothing to change the fact that the ground beneath our feet isn’t there anymore. The debts keep mounting, the currency keeps depreciating, and eventually people will start running for the exits. In the meantime, I will reiterate my recommendations from a previous article and add a new one.

I continue to expect gold to appreciate. In an environment where nothing seems safe, a huge amount of money is going to be looking for a safe-haven. Traditionally, gold is considered the safest of safe-havens, and there’s not much of it around in comparison to the amount of money that could soon be looking for a home.

Secondly, buy the yen against the dollar. Other world currencies have already risen to record levels against the crumbling dollar, but the yen hasn’t yet. With US short-term interest rates falling, the “carry-trade” (whereby investors can make easy profits by borrowing yen at low rates and investing in dollar-denominated assets at higher rates of interest) will become increasingly unattractive, and once the dollar begins to fall vis-à-vis the yen, the huge amounts of money that have been put into the carry-trade over the past decade will start to reverse directions, thereby exacerbating the slide of the dollar.

Thirdly, sell US bank stocks short. Despite the fact that everyone now acknowledges that the housing market is crashing, prices haven’t fallen by much yet. Nevertheless, leading financial institutions have racked up huge losses already. Merrill Lynch’s recent write-down of $8 billion and the resignation of its CEO is just the beginning. After all, if firms are feeling this level of pain from a real estate market that has only experienced single-digit declines so far, what’s going to happen if prices fall 20 or 30 percent? (Hint: bankruptcy.)

Lastly, although I am hesitant to bet against the stock market’s persistent ability to rise in the face of bad news, it is my feeling that the Fed has shot its load for the time-being in terms of monetary policy. Yes, the Fed Funds still stands at 4.5%, so they could keep cutting, but at this point they’re not getting any bang for their buck, and its becoming increasingly clear that the costs in terms of undermining the value of the dollar are outweighing the stimulative effects to the financial system. I can’t remember where I read it, but I recently saw someone make the distinction between illiquidity and insolvency, as it relates to the efficacy of monetary policy. The point is that if a crisis is caused by a short-term liquidity crunch but corporate finances are otherwise healthy, an injection of money by the central bank can be an effective remedy. If, on the other hand, firms’ long-term financial positions are fundamentally unsound, measures aimed to shore up short-term liquidity (e.g. cuts in short-term interest rates) can’t do anything to solve the problem. This is why it is my belief that the Fed is becoming increasingly impotent to solve the deepening crisis. Short-term liquidity won’t do anything to bail out companies (or individuals) who have fundamental, long-term financial imbalances. There is nothing in the monetary tool-box that can solve such problems (with the exception of a wholesale devaluation of the currency). Therefore, I believe that the ability of the stock market to hold up based on expectations of future rate-cuts is nearing an end, so I recommend shorting the US stock market at this point.

Good luck…

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