Progress Pond

Global No-Confidence Vote: Day 3

So the Fed’s emergency rate cut, described to me by one colleague as “biting your leg off to escape the trap” has had some effects on the markets this morning.

But they aren’t what investors expected.

Most Asian markets rebounded Wednesday, reversing their recent gut-wrenching plunge as investors welcomed a hefty, surprise interest rate cut by the U.S. Federal Reserve to shore up the sagging American economy.

But European markets slipped in early trading.

Analysts said the market turmoil would linger for some time because the Fed’s emergency action was seen by some as a sign American authorities view the U.S. credit crunch as a very serious problem.

“The Fed’s action provided a very positive surprise,” said Tsuyoshi Segawa, strategist at Shinko Securities Co. in Tokyo. “But people are also starting to think that things may be so bad they needed to act.”

When you spend several year pretending there’s no problem and then make the most drastic rate cut in decades on an idle Tuesday, you get into a can’t win situation.  Psychologically, the smart folks in the finance world are very, very concerned still.  They still believe we’re trying to inflate our way out of a problem when they know full well that it won’t work this time, because the problem isn’t interest rates or even “the credit crunch”.

It’s much more fundamental then that.  It’s a question of “How much do I have?”  When people don’t know what the paper they are holding is worth, people hesitate to do anything with the money they DO have.

If 95% of the assets you had were in IOU’s from somebody and you weren’t sure they were going to pay you back, the 5% of assets you have in cash you’re going to be very careful with.  And the hundreds of trillions of dollars in derivatives are just that:  nothing more than a global IOU market.  That’s a simplistic view, but it’s generally the idea:  the securitization of debt and speculation of future monetary and fiscal trends.  And they’re built on the notion that “Hey, I’m good for that IOU, I’m too big to fail.”

Only in 2007, the mortgage and financial folks starting failing anyway.  That started making people nervous. People buy, trade and sell derrivative contracts — glorified IOUs — worth billions and even trillions.  But the subprime housing crisis has caused a possibly fatal problem with derivatives, namely people are beginning to want something a bit more worthwhile for their IOUs.  

Let’s say you stockpile a bunch of goods and issue out paper called X to represent them.  Basic economics says that if everyone agrees on the value of X, then X can be used to trade for goods and services.  But you have to have the agreed upon baseline value to back up X.

That fraction of the value people actually have sitting around that isn’t on paper is very, very, very low.  A fraction of a percent, in fact.  The whole global financial system is based on it.  Nobody’s going to call you out on the whole thing because they know you’re not going to be able to pay it back to them when they come in with their X and want your goods backing up your IOU.

The goods backing up X of course used to be gold.  Now?  Now it’s a lot murkier.  If everyone comes calling at once for their goods and you have a fraction of a percent, everybody’s screwed.  That’s why nobody calls it in all at once.  But if you don’t call SOME of it in, you lose.  You don’t want to be the only guy holding  X when other people are trading in their X for goods.

One guy trading in 100% of X would ruin the market.  But so does 1000 guys trading in 0.1% of X and expecting to all get paid.  The latter is the real problem.

The modern fractional reserve system is just a bunch of glorified IOUs.

And this week?  They’re coming due.

In Hong Kong, the Hang Seng index surged 10.7 percent – its biggest gain 10 years – to 24,090.17, regaining much of the 13.7 percent it had shed over the previous two days.

Japan’s Nikkei 225 index rose 2 percent to close at 12,829.06 after tumbling 9.3 percent the previous two days, while India’s Sensex was up 5.7 percent in afternoon trading, recapturing nearly half its 12 percent losses from Monday and Tuesday.

In Shanghai, China’s benchmark index, which sank 12 percent earlier this week, bounced back 3.1 percent, and Australia’s market rebounded 4.4 percent, snapping a 12-day losing streak.

Hey, the Asians are hunting bargains now.  Crisis averted, yes?

Not really.

Investors in Asia were already factoring in another U.S. rate cut of as much a half-point when the Fed holds its regular meeting on Jan. 29-30, traders said. But Asian markets could slide back if Wall Street continues to decline in coming sessions, they warned.

So, let me get this straight.  Asian markets have priced in a 1.25% interest rate cut in the space of ten days.  They are STILL expecting the same half point rate cut on January 30 even AFTER the .75% rate cut yesterday.  It’s madness.  Again, what happens when we’re out of rate to cut?  At this rate of rate cutting, a quarter point every 2 days, that’ll be about a month from now when the rate hits zero.

Seems nuts, huh?  But this is the Bush administration…and it’s an election year.

You’d think Wall Street would be loving that rate cut.

You’d be wrong.

Wall Street looked set to take another beating Wednesday, as investors reacted to disappointing outlooks from Apple and Motorola and remained haunted by recession fears.

At 7:35 a.m. ET, Nasdaq and S&P futures were sharply lower, suggesting steep losses at the start of trading once again.

The markets were down yesterday too.  That rate cut turned a bloodbath into a bad day, with the bloodbath coming slightly later on.

Why?  Well first, like I said, there’s only so much rate to cut.  And second, when’s the last time you remember a 75 basis point rate cut that STILL pissed off the market?

Three-quarters of a percentage point was not enough.  It’s still not enough.  Eventually somebody’s going to figure out that cutting interest rates are only going to make things worse in this situation.  Europe’s giving back the gains it made yesterday.  Wall Street is going to continue to drop.

Asia at least has the manufacturing base, but they’re still down too…and who are they going to sell stuff to if we don’t buy it?  Especially if those transactions that are still being made are made in increasingly worthless US dollars?

Now let’s factor in the uncertainty of the subprime mess meaning people don’t know what those IOUs are really worth anymore.  Derivatives were a problem long before, but this is the factor that made people question the emperor’s clothing dearth.

At its heart, economics is psychology.  And right now people are scared, unsure, angry, and worried.  That’s bad.

It almost sounds like they have…no confidence.  No Confidence, Day 3.  All bets are off.

Update [2008-1-23 12:39:32 by Zandar1]: It’s noonish here, Dow started out down 200 right off the bat, rebounded some…and is now back down 200. The Euros looked at the rate cut and everyone expected them to follow suit.

You’d be wrong.

European Central Bank President Jean-Claude Trichet appeared to slam the door on an interest rate cut, contributing to another round of selling in global stock markets and prompting second-guessing among market watchers.

Trichet’s signal came amid growing hopes that central banks around the globe would follow up on the Fed’s three-quarter of a percent cut in the fed funds rate Tuesday to help calm equity markets and jumpstart growth amid a growing sense of dread about a US recession.

Instead, Trichet emphasized the need to fight inflation, saying “In demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets.”

Market watchers were surprised by the bluntness of the statement.

I’m not surprised at all. The Euros know we’re screwed and that we’re going to take them down with us. Furthermore, they know the problem isn’t interest rates and can’t be solved by cuts. It’s basic fundamental solvency, not interest rates. And people don’t know if they are solvent or not.

Meanwhile, we’re pretending there’s no problem still.

The slowing economy will not sink into an election-year recession and an economic rebound is likely beginning next year as housing and financial market turmoil fades, the Congressional Budget Office forecast Wednesday.

In the meantime, the U.S. budget deficit will grow to $219 billion this year, up from the $163 billion registered last year, according to a CBO report submitted to Congress.

But that forecast by Congress’ nonpartisan budget analyst does not include the cost of an economic stimulus measure that is quickly moving through Congress and could cost around $150 billion or more. The deficit projection for fiscal 2008, which ends Sept. 30, also does not include more money Congress is likely to approve this year for the war in Iraq.

“Although recent data suggest that the probability of a recession in 2008 has increased, CBO does not expect the slowdown in economic growth to be large enough to register as a recession,” CBO said.

We’re fine! We’re all fine. It’s not a recession. It’s a hiccup. The economy is strong!

So, you believe this government line? It’s right up there with “We don’t torture” and “We don’t spy on Americans” and “We know Saddam has WMD” and “The Iraq war will cost 50-60 billion dollars and pay for itself”.

Add “We do not expect the slowdown in economic growth to be large enough to register as a recession.”

Do you have confidence in that? The markets don’t. No confidence continues.

Update [2008-1-23 13:53:11 by Zandar1]: Dow’s still bouncing around, and now the “smart money” is on ANOTHER 75 basis point cut.

February fed funds futures now suggest an 81% chance that the Fed will cut its target for overnight rates to 2.75% from 3.5% at its policy-setting meeting on Jan. 30. The odds of a half-point cut rose to 122%.

Late Tuesday, the futures were pricing in a 90% chance of a half-point cut and a 60% chance of a three-quarter point cut next week.

So, a 1.5% rate cut in 10 days. That’ll work!

Right?

Update [2008-1-23 15:57:14 by Zandar1]:Dow staging a rally. In this business, we call it the ol’ dead cat bounce.

As long as we’ve got rates to cut, the investors will buy it. The market’s expecting another massive rate cut next week.

So which will we run out of first, rate cuts, or bad news writedowns from hidden subprime damage?

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