donsutherland1

Today’s market activity revealed that the overnight money markets that had been breaking down last week were continuing to calm. However, it also renewed the point that the transition from last week’s near panic to a more stable future is not likely to be easy.

A financial rescue plan will not provide a quick fix, even as it stabilizes some of the problems plaguing the financial sector. Stock prices may yet reach new lows, home prices are likely to linger well below their earlier highs for years to come, and the economy may yet fall into recession.

Today’s trading featured a historic spike in the price of crude oil. The price of crude oil on the October futures contract settled at $120.92, up $16.37 per barrel. A large part of the increase occurred on account of short-covering ahead of the expiration of the October futures contract. Nevertheless, the November contract also rose more than $6 per barrel. At the same time, gold rose more than $40 per ounce. Such a flight to commodities revealed concern about the financial rescue package’s impact on the U.S. dollar.

Had Washington maintained a record of fiscal restraint, that record might have mitigated some of the markets’ concern. However, in recent years fiscal extravagance has been the rule and there is at least a measure of concern that Washington could attempt to reflate its way out of the current financial challenge. Should foreign investment in the U.S. show signs of weakening at a time when the U.S. needs more robust capital inflows from abroad, that could send interest rates higher. In turn, the higher interest rates could exacerbate the challenges facing banks that suffer from a large asset-liability mismatch, in which their assets are largely long-term in nature while their liabilities are short-term.

When it comes to mortgage debt, a gradual but sustained de-leveraging is both necessary and likely and such de-levering will dampen consumer spending. Mortgage debt continues to run near historic highs:

Mortgage Debt Outstanding (% of GDP):
2004 91.3%
2005 97.5%
2006 102.6%
2007 105.8%
2008 103.4% (2008 Q2)

That figure will need to gradually decline and the process could require several years before the nation's mortgage debt burden becomes more manageable.

For that to happen, individual saving will need to increase, and there are the first hints that such increased saving may be starting to take place. The saving and investment information released by the Federal Reserve on September 18 revealed that personal saving rose dramatically from $20.6 billion in Q1 to $279.9 billion in Q2. Should that trend persist, real personal consumption expenditures will decline relative to GDP and possibly on a quarterly basis later this year or next year. That decline in real personal consumption expenditures would strengthen the headwinds already buffeting the economy and heighten the risk of a recession later this year and into at least the first part of next year.

In addition, even as the world’s central banks have pumped fresh liquidity into the money markets and a number have cut interest rates in the past week, there remains little assurance that the risk aversion that has now descended on the tormented financial services industry will not lead to a sustained credit squeeze, and possibly, an all-out credit crunch. After all, during the Japanese banking crisis that followed the collapse of that countries twin asset bubbles during the early 1990s, banks wound up accumulating the cash that was poured into the economy by the government. Bond investor Michael Cheah expressed worry that banks could use the cash they receive from unloading their toxic debt under the Paulson rescue plan to purchase Treasuries.

James Awad, managing director at Zephyr Management added, “In the corporate sector everybody’s in a protect-your-balance-sheet mode. Most corporate executives are going to think cash is king.” In short, corporate investment in expansion is likely to slow, as is hiring.

In conclusion, today’s market activity revealed that even as some form of the Paulson rescue plan is likely to be adopted, perhaps sometime in the next 1-2 weeks, real risks persist. It remains plausible that those risks could conspire to drive the economy into recession later this year.