It does seem to be the case that the risk of financial collapse is much smaller now than a few months ago. Every major government has made clear its intention to do whatever is necessary to bail out whatever is necessary to prevent cascading losses. This is certainly a huge positive for stock market valuations.

Increasingly, though, the pervasive view has become that the worst of the downturn is behind us and that we shall soon see the beginnings of recovery. This spreading belief seems to be what underlies the persistence of the rally. The continuation of the rally, or even the maintenance of the current level of the stock market is dependent on the validation of this rosy view by actual performance in the coming months. If output continues to decline, or profits erode more seriously than now expected, the market seems likely to head downward again.

Thus, forecasting the stock market now seems more tied to forecasting the economy than it has been since the collapse of the market last Fall, a collapse driven by the dawning realization of the extent and the impact of the toxic assets spread around the world. My own view is that there are more negatives than are being taken seriously by the optimists. We are in waters that haven’t been visited since the depression of the 1930′s, and with the added uncertainties created by the extent of interconnectedness of the world economies and financial institutions. It seems too good to be true that the economies of the world can simply shrug off all of the major dislocations that have occurred in the last six months. In my experience, most things that seem too good to be true are…

Here are the views of two people that accurately warned of last year’s debacle, Nouriel Roubini and Gary Shilling, both of whom I’ve cited before. Roubini’s views are what I would call now almost mainstream, since the mainstream has joined him – although he continues to be more pessimistic. Shilling’s views are more iconoclastic, especially with respect to inflation versus deflation. Recognize, though that Federal Reserve Chairman Bernanke has repeatedly voiced his concern about deflation and his determination not to let it happen.

RGE Monitor’s Newsletter

Greetings from RGE Monitor!
Today we present some of the main conclusions of the recently released update to the RGE 2009 Global Economic Outlook.

The global economy is in the middle of a synchronized contraction that will push global growth into negative territory in 2009 for the first time in decades. . This will be the worst financial crisis since the Great Depression and the worst global economic downturn in decades. Global trade volumes face their sharpest contractions of the postwar era – trade is expected to contract 12% in 2009 due to the severe and prolonged global demand slump, excess capacity across supply chains and the continued crunch in trade finance.
Many analysts and commentators are pointing out that the second derivative of economic activity is turning positive (i.e. economies are still contracting but a slower rather than accelerated rate) and that green shoots of an economic recovery are blossoming. RGE Monitor’s analysis of the data suggests that the global economic contraction is still in full swing with a very severe, a deep and protracted U-shaped recession. Last year’s economic consensus forecast of a V-shaped short and shallow recession has vanished. While the rate of economic contraction is slowing compared to the free fall rates of Q4 of 2008 and Q1 of 2009, we are still a long way away from the economic bottom and from a sustained recovery of growth. In particular, in Europe and Japan there is little evidence of a positive second derivative of economic activity.
However by the end of Q1 2009, there were some signs that the pace of contraction had slowed in many economies especially in the U.S. and China, where policy responses have been more significant and leading indicators in the manufacturing sector may have bottomed before they did in Europe and Japan. However, major economies including all of the G7 will continue to contract throughout 2009, albeit at a slower pace than at the beginning of the year.
Moreover the global recovery might be sluggish at best in 2010 given the overhang of credit losses of financial institutions, lingering credit crunch, need for retrenchment by overstretched and over-indebted households in current account deficit countries and a slow resumption of demand prompted by extensive government stimulus.

Some key elements of RGE Monitor’s outlook include:

• Global economic activity is expected to contract by 1.9% in 2009. Advanced economies are expected to contract 4% in 2009. Japan and the eurozone will suffer the sharpest downturns. U.S. GDP will continue to contract, albeit at a slower pace throughout 2009, with negative growth in every quarter.

• Emerging markets will slow down sharply from the stellar growth rates of the past few years, with the BRIC economies growing at half their 2008 pace.

• Deteriorated terms of trade, slower capital flows and tighter credit will push Latin America into recession from the 4.1% growth of 2008. Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela will all shift to negative territory on a year-over-year basis while smaller countries, like Peru, will experience a significant slowdown.

• Countries in Eastern Europe and the CIS will experience some of the sharpest contractions given the withdrawal of foreign credit and the risk of a severe financial crisis. The reduction in oil revenues and financial stress will contribute to a 5% yoy contraction in Russia and some countries – especially in the Baltics – are at risk of double-digit contractions.

• Export-dependent Asia’s growth will slow significantly to less than 3% in 2009. China will have a hard landing with GDP growth falling to 5.5% while India will slow sharply to 4.3%. All four Asian Tigers (Singapore, Taiwan, South Korea and Hong Kong) as well as Malaysia and Thailand will experience recessions.

• The Middle East and Africa will mark much slower growth, half of their 2008 pace, given the reduction in capital inflows, reduced demand from the U.S. and EU and decline in commodity prices and output. Israel and South Africa will suffer slight contractions.

• The unprecedented fiscal and monetary stimulus may help alleviate the substantial contraction in private demand and reduce the risk of a global L-shaped near-depression. Debt financing may be a challenge for many countries though, especially emerging markets or the most vulnerable Western European economies.

• Job losses during the current global recession might exceed those in recent recession, contributing to increases in defaults and posing additional risks to banks. The unemployment rate in developed countries will reach double-digits by 2010 (as early as mid-2009 in the U.S.) and push more people in developing countries into poverty. Moreover, despite new funding from multilateral institutions, severe contractions will raise the risk of social and political unrest.

• Commodities as a class are likely to come under renewed pressure in 2009 despite some support from production cuts. RGE expects the WTI oil price to average about $40 a barrel in 2009 as demand destruction continues to outweigh crude supply destruction.

Long-Term Outlook: Slow Growth And Deflation

(excerpted from the March 2009 edition of A. Gary Shilling’s INSIGHT)

From 1982 until 2000, the U.S. economy enjoyed rapid growth with real GDP rising at a 3.6% average annual rate. Furthermore, this 18-year expansion, which cumulated to an 89% rise in inflation-adjusted economic activity, was interrupted by only one recession, the relatively mild 1990-1991 downturn, which depressed real GDP by only 1.3% from peak to trough.

Extended Expansion

From a fundamental standpoint, the growth spurt ended in 2000 as shown by basic measures of the economy’s health. The stock market, that most fundamental measure of business fitness and sentiment, essentially reached its peak with the dot com blow-off in 2000 and has been trending down ever since (Chart 1). The same is true of employment, goods production and household net worth in relation to disposable (after-tax) income.

Nevertheless, the gigantic policy ease in Washington in response to the stock market collapse and 9/11 gave the illusion that all was well and that the growth trend had resumed. The Fed rapidly cut its target rate from 6.5% to 1% and held it there for 12 months to provide more-than ample monetary stimulus. Meanwhile, federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus.

As a result, the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to housing (Chart 2), commodities, foreign currencies, emerging market equities and debt, hedge funds and private equity. Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would. Thus persisted what we earlier dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Not Sustainable

Even before these final speculative binges, the forces driving the economy in its long expansion were unsustainable, as we’ve been stressing for years in Insight. These forces included the decline in the consumer saving rate and jump in consumer debt, the vast leveraging of the financial sector, increasingly freer trade and loose financial regulation, all of which are now being reversed.

In the 1980s and 1990s, American consumers were more than willing to cut their saving rate because they believed stock portfolios would continue to grow rapidly and take care of all their financial needs. Then, when stocks collapsed in 2000-2002, house appreciation (Chart 3) seamlessly took over to continue the push down the household saving rate from 12% in the early 1980s to zero. Americans saw their houses as continually-filling piggybanks because, they believed, home price appreciation would continue indefinitely. They tapped that equity freely with home equity loans and cash-out refinancing.

The flip side of saving less is borrowing more, as evidenced by the leap in all consumer debt and debt service, both in relation to disposable (after-tax) income and relative to assets. In relation to GDP, the cumulative outside financing of the household as well as the financial sector leaped for three decades, measuring the immense leveraging in these two areas. Not surprising, amidst this consumer borrowing and spending binge, consumer spending’s share of GDP leaped from 62% in the early 1980s to 71% at its peak in the second quarter of 2008 (Chart 4).

The Tide Turns

Now, however, consumers have run out of borrowing power. As of the third quarter 2008, homeowners with mortgages had on average 25% equity in their abodes after all mortgage debt was removed and that number will probably drop to the 10%-15% range with the further decline in house prices we are forecasting (Chart 3). At that bottom, after a 37% peak-to-trough collapse, almost 25 million homeowners, or nearly half the 51 million with mortgages, will be under water, with their mortgages bigger than their house values. In total, the gap will be about $1 trillion.

The nosedive in stocks has also discouraged consumer spending as have mounting layoffs (Chart 5), maxed out credit cards and tighter lending standards and weak consumer confidence. Rising medical costs are also a drag on consumers as their co-pays and deductibles mount. For decades, credit card issuers and other lenders encouraged consumers to indulge in instant gratification. Buy now, pay later. But now, habits are changing. Debit cards are becoming popular since they deduct charges directly from the user’s checking account and, therefore, don’t increase indebtedness. Layaway plans are back in style after nearly disappearing.

[The article continues with much, much more analysis and insight]

As one commentator, whose name I can’t recall, said recently, “There is no rush to get back in the market. There will continue to be plenty of opportunities for highly profitable investments well after the future is much clearer than it is now.”

Reuters

Wed Dec 17, 2008 7:08am EST  — John Kemp is a Reuters columnist. The views expressed are his own —

Fed unleashes greatest bubble of all

By John Kemp

Like the sorcerer’s apprentice, Federal Reserve Chairman Ben Bernanke and his predecessor Alan Greenspan have unleashed a series of ever-larger asset bubbles they cannot control.

Now the Fed’s decision to cut interest rates to between zero and 0.25 percent, coupled with a promise to  keep them there for an extended period, and the threat to conduct even more unconventional operations in the longer-dated Treasury market risks the biggest bubble of all, this time in the U.S. government debt.

THE ASYMMETRIC EXPERIMENT

Bubble mania is no accident. It is the direct consequence of the Fed’s asymmetric response to shifts in asset prices. Pressed to "lean against the wind" and adopt counter-cyclical interest rate and credit policies in the asset market, senior Fed policymakers have repeatedly demurred.

Led by Bernanke and Greenspan, officials have argued it is too hard and subjective to identify bubbles until afterwards, and not the Fed’s job to second-guess asset allocation decisions of professional investors.

Even if bubbles could be identified, they argue, pricking them would require swinging rate rises that would inflict widespread damage on the rest of the economy.

Far less damaging to allow asset markets to follow their natural cycle and stand by to cut interest rates sharply, supply liquidity and contain the fallout when the bubble bursts.

But the Fed’s asymmetric policy response to rising and falling asset prices (colloquially known as the "Greenspan/Bernanke put") directly led to much of the excessive risk-taking which has humbled the financial system over the last eighteen months.

More importantly, the Fed’s decision to respond to the collapse of the technology and stock market bubble by lowering rates to 1 percent and holding them there for an extended period is now widely accepted as a mistake that contributed to the bond bubble and subsequent housing market boom in the middle of the decade.

If the low-rate strategy was a mistake, it was a conscious one. In testimony to the UK Parliament last year, former Bank of England Governor Eddie George admitted the bank had deliberately sought to stimulate the housing market and house prices to support consumption during the downturn. Greenspan, Bernanke and Co seem to have adopted a similar approach in the United States.

The real mistake, however, was not creating one bubble to offset the collapse of another, but believing they could control what they had wrought.

When the Fed did eventually start to raise short-term interest rates in 2004, long rates remained stubbornly low for a year, and then rose much more slowly than anticipated, a development the puzzled Fed chairman and his able assistant Dr Bernanke described as "the Great Conundrum."

Even as rates eventually rose, the alchemy of securitization ensured the real cost of credit remained far too low until the subprime bubble finally burst in late 2007.

The second mistake is a basic design flaw in the Fed’s "risk-management" approach to setting monetary policy. Risk management is a nice idea, but not terribly useful. As engineer will explain, risk management involves trade offs and is not cost-free.

The Fed has struggled to formulate a response to "low probability, high impact" events such as the threat of deflation in the early 2000s. Its response has been to cut rates aggressively to ward off the danger of extreme downside events, a strategy officials liken to taking out an insurance policy.

That’s fine, but when these low risk events have not in fact occurred, as was never statistically likely, the resulting policy settings have proved far too loose, and the central bank much too slow to change it.

Concentrating on theoretical but small risks such as deflation has too often blinded the Fed to much larger risks near at hand of bubbles and asset inflation.

INTO THE UNKNOWN

Even as officials recognize policy has played a role stimulating an endless series of bubbles, the Fed finds itself trapped with no way out. Following the collapse of much of the modern banking system, the risk of pernicious deflation is now very real–more so than in the early 2000s.

So like the sorcerer’s apprentice, the Fed has cranked up the Great Bubble Machine for what policymakers hope will be one final time.

The Fed’s "unconventional" monetary strategy comes in four parts:

(1) Cutting interest rates to near-zero to lower the cost of borrowing.

(2) Injecting short-term liquidity into the financial system in the form of bank reserves (quantitative easing).

(3) Trying to pull down yields on longer-dated Treasury bonds through a combination of the jawbone (promising to keep short rates low for an extended period) and the threat to intervene in the market directly by buying longer-dated paper.

(4) Trying to reduce credit spreads above the Treasury yield for other borrowers, and increase the quantity of credit available, by buying mortgage-backed agency bonds for its own account, and financing other market participants to buy securities backed by other consumer credits, auto loans and student loans.

Most attention has focused on the zero-rate policy and quantitative easing at the short end of the curve. But the real significance lies in the unconventional operations targeting Treasury yields and eventually credit spreads at the long end.

Operations at the short end are designed to bolster the banking system and restart lending. But the Fed knows the banking system is not large enough to replace the much more important sources of credit from securities markets.

Operations at the long end are designed to get bond finance and securitized credit flowing. Short-end interest rates and quantitative operations are significant because they help shape the whole term structure of interest rates embedded in the curve.

ONE LAST SUPER-BUBBLE

The strategy has already succeeded in halving yields from over 4 percent in mid October to just 2.25 percent now.

By convincing investors interest rates will remain ultra low for a long period, the Fed has made them willing to lend to the U.S. government for up to ten years for what is a paltry return.

There are two risks. First, the massive rise in bond prices and compression of yields has come in the secondary market. The U.S. Treasury has not yet succeeded in placing much of its massively expanded debt and new requirements for next year at such low levels. But given the panic-driven demand for default-free assets, officials should not have too much difficulty.

The bigger one is that the Fed is misleading investors into the biggest bubble of all time. Bernanke is making what learned economists call a "time-inconsistent" promise to hold interest rates at ultra low levels for an extended period.

The problem is that if the unconventional monetary policy works, and the economy picks up, the Fed will come under pressure to "normalize" rates and reduce excess liquidity to prevent a rise in inflation. The resulting rate rises will inflict massive losses on anyone who bought bonds at today 2.25 percent rate.

Bizarrely, Bernanke and Co are in fact inviting investors to bet the policy will fail, the economy will remain mired in slump for a long period, deflation will occur and interest rates will remain on the floor, as Japan’s have done since the 1990s.

Buyers of real estate and subprime securities have recently been lampooned for foolishly overpaying at the top of the market. Bernanke and Co are gambling memories will prove short and investors will prove just as eager to pay top prices for long-term government and private debt even though the downside is large.

Let us have one last bubble, and when it collapses, we promise not to do any more in future…honest.

© Thomson Reuters 2009 All rights reserved

"Why should I care?" would be an understandable response to this topic. Inflation/deflation seems pretty far removed from concerns about economic and/or financial collapse. In truth, though, they are very central to the policies being pursued by the Federal Reserve. As you are likely to be aware, Mr. Bernanke has been anything but restrained in expanding the debt of the Federal Reserve and taking other measures aimed at expanding the money supply and keeping interest rates low. He has been explicit that much of his motivation is to avoid deflation, a falling off of prices. In his view, deflation is a specter so fearsome as to be avoided at all costs.

Why, you may wonder, is deflation such a bad thing? I have wondered the same thing myself. The underlying reason, it turns out, is the same reason that we are having a financial/economic crisis — the huge over-expansion of debt. As the economy contracts, many of those debt holders become hard pressed to pay back their debts. If prices decline, the burden of debt becomes even larger, because one needs to pay back with dollars that are harder to earn. Conversely, inflation has the opposite effect.

Consider, if inflation goes on at 3% per year, each year, one’s profits will increase by 3% per year just as a result of the inflation (leaving aside possible real effects on profits). In 10 years, due to compounding interest, $1 million of debt today will be able to be paid back in ten years for $750,000 of today’s dollars (which will increase due to inflation to the $1 million owed). Conversely, if prices decline by 3% per year, $1 million of debt today will take $1.34 million of today’s dollars to pay back ten year’s hence.

If deflation sets in, it makes outstanding debt burdens more onerous, and it also discourages taking on new debt for investment because the deflation effectively raises the interest rate. The Federal Reserve can’t lower interest rates below zero; so monetary policy is limited in its scope. Less investment will contribute to pushing the economy downward, which can then contribute to further deflation — and so on.

Mr. Bernanke believes that the deflation cycle was one of the major contributors to making the 1930′s depression so severe, explaining why he is so dedicated to preventing its recurrence.

Not everyone is so sure Mr. Bernanke is right or that he will achieve his goal of preventing deflation. Perhaps an even larger number believe that even if he is able to prevent deflation, he is doing so only at the cost of creating an unavoidable much larger inflation in the future. Mr. Bernanke answers such critics by saying that when the time comes, when the economy begins to expand, he will "mop up" all of the excess money in the system so that inflation won’t occur.

Who is right about this is not just an academic question. The huge increase in Federal Reserve debt, plus the huge increase in Treasury debt to finance the big federal deficits, are not matters of debate. They are fact. These create pressures toward higher interest rates for government bonds. However, the Federal Reserve to date has succeeded (or had "good fortune") to have very low interest rates for Treasury bonds.

If we have deflation, Treasury interests rates, although low, may persist or fall further, making Treasury bonds a good investment. Conversely, if serious inflation occurs, interest rates will follow suit and the price of such bonds will fall substantially. Whether bond prices will rise or fall in the future is a key question for all of those who now own the $6 trillion of publicly held U.S. debt.

As The Federal Reserve’s policies are official policy, they receive a great deal of media coverage of the rationale for them. Less coverage is provided to opposing views. I, therefore, concentrate on providing space for opposing, and to me very credible, critiques.

The first one in the series is from Reuters’ columnist John Kemp on the inherent contradiction of the Federal Reserve’s current efforts to push down and keep down long-term government bond interest rates.