Different Strokes For Different Folks

September 15, 2008

A day like today challenged market analysts like few do.  In light of a revamped institutional architecture, forecasting would be a crap-shoot but a task that could not be dodged in markets starved for any short-term trading advice or policy tips. I took the safe route that the Fed will cut rates tomorrow, which overnight had become a universally held opinion, and the slightly more risky call that more than 25 basis points would be needed before yearend.  I added that rate reductions by other central banks seem more plausible, but stopped short of indicating high confidence that easing will escalate immediately.

I chose not to endorse or criticize the decision by the Fed and U.S. Treasury not to bail out Lehman.  What’s done is done, and it is clear that the credit crisis will go on.  I’m not surprised that views on the Lehman bankruptcy have been mixed.  The Wall Street Journal’s editorial assertion that “Treasury Secretary Hank Paulson’s refusal to blink won’t get any second guessing from us” was a predictable reaction.  So was New York Times columnist Krugman’s more measured response that officials had become understandably worried about the mounting taxpayer burden and that repeated “rescue efforts will encourage even more risky behavior in the future” but the possibility now that “trying to liquidate [Lehman’s balance sheet quickly could lead to panic across the financial system.”  With no guaranteed ways out of the present mess, the Financial Times avoided blame or acclaim altogether and devoted the main editorial to how the weekend events have shifted the danger of stagflation, which until now has frozen interest rate policy in Japan and Europe, to a risk now skewed toward weakening growth, and therefore deflation.  After additionally documenting a widening disparity between headline and core inflation even as commodity prices are now falling, the FT recommended that European central banks not delay rate reductions any further.

As I noted in the previous post, a first indication of the European central bank response will come from a scheduled quarterly  meeting this week by the Swiss National Bank.  I initially doubted that either the SNB or the Bank of Japan would cut rates this week, but that possibility looks greater now than a few hours ago.  I wanted to see how U.S. equities, bonds, and oil reacted today.  The pattern has been alarming. On many occasions this year and before, sharp drops in European and Japanese share values did not carry into U.S. markets.  For instance, the Nikkei fell last Monday by 2.8% following the nationalizations of Fannie and Freddie, yet the DJIA gained 2.6% that day.  This time the U.S. levies did not hold: the DJIA closed down 504 points and 4.4%, and the Nasdaq lost 91 points (3.6%).  We’ve seen bigger point declines:  416 on February 28, 2007, 685 when trading resumed after the 9/11 attacks, 617 on April 14,2000,  554 on October 27, 1997, and 508 points on October 19, 1987 (equivalent to -22.6%).  A 22.6% decline now would have hammered the DJIA all the way down to 8,841.  Nonetheless, the movement today does not bode well for Chinese and Japanese stocks tonight, which were spared Monday’s slaughter because of holidays, nor for U.S. and Europe tomorrow.  If the situation threatens to snowball, the ECB and Bank of England always could choose to act before their scheduled October meetings.

A global central bank relief also is suggested by today’s drop in ten-year yields of 20 basis points in the United States and Britain and of 15 basis points in Germany.  Likewise, another 6% drop in oil prices despite Hurricane Ike heralds a tilt in policy priorities that should downgrade the threat of inflation.  To me, however, the real issue is not how soon the Bank of England and ECB cut rates but how aggressively they move.  One thing is for sure.  Rates will not be reduced in Europe as rapidly as the breathtaking 225-basis point additional drop to 2.0% engineered by the Fed within 99 days between January 22nd and April 30th of this year, which came after 100 basis points of relief during the final third of 2007.  The dollar did poorly in 1Q08 but much better subsequently as rate spreads stabilized and other issues caused by deleveraging and risk aversion moved to the fore.



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