Monday, June 16, 2008


Could it get any worse?

I want to paint a picture for you so that you understand why I am so worried right now. The chart to the left is the Ten year U.S. treasuries which you can see is falling (yields rising) right now. What I don't have pictured is the Two year which is falling even faster. All of the squawking you have heard lately from the Fed about getting tough on inflation and raising rates. Well the market is doing it for them. In fact, the market almost always leads the Fed around rather than the common perception. If short term rates go up much more the Fed might be forced to act. More on that later.

It's later. This is the chart of the Euro and to my trained eye I can tell you that it looks like a market that is biding its time before it heads higher. This is the Fed's rock to the stock market hard place. The Fed fails to raise the Fed funds rate as the U.S. treasuries are rising and they risk the dollar going into free fall.

The stock market has been dropping quickly since the May 16th high which after a long volatile upwards correction is the perfect set up for a bearish trade. Of course any move above 12,500 will have us Bears scrambling to cover. This is the perfect set up for a crash but we have to keep going down quickly in order to make it work. So actually, this is the perfect set up for more volatility because the one scenario that is hard for me to imagine is stocks sitting here. So expect a lot of big moves, just that down looks better right now.

One more thing. The Chinese Shanghai index is down nearly 50% from its peak in January. I think it is safe to say that their bubble is over. It remains to be seen what that means for us. They do own a lot of our treasuries but I don't see them dumping them because of this.

So what is to be made of all this? That's right, it is 1987 all over again. I will leave you with some quotes from one of the few big name economists outside of Wall Street who has gotten this right, Robert Shiller.

There’s another, more urgent reason to focus on the idea of social contagion today. Like booms, many busts are magnified by group thinking. And once busts become severe enough, they prompt changes in the national mood that ramify well beyond economic affairs. Benjamin M. Friedman, in his 2005 book, The Moral Consequences of Economic Growth, cites abundant historical evidence that when economic prospects look bleak—especially for long periods of time—intolerance, racism, and other reactionary impulses flourish. As more people experience hardship, trust between them tends to diminish, and the social fabric itself seems to fray.

If home prices keep dropping, more bailouts of banks and broker-dealers likely will be necessary to prevent the paralysis of the financial system and a severe loss of confidence in our economy and economic institutions. And if we aim to stop foreclosures, with all their ugly consequences, from spreading further, many, many homeowners are going to need loan refinancing—which will need to be provided or backed by the government. Bailouts of investors and prospective bailouts of unwise or unlucky home buyers have stirred a lot of controversy, and indeed, financial bailouts are, for many reasons, unsavory. But given the severity of the current financial seize-up, they are needed—not to prop up Wall Street profits or housing prices, but to prevent a fundamental loss of economic confidence and to maintain a sense of social justice for those of modest means. Losses of confidence and trust can mount with surprising speed, and beyond a certain point they become very difficult to recover from.

We recently lived through two epidemics of excessive financial optimism. I believe that we are close to a third epidemic, only this one would spread irrational pessimism and mistrust—not exuberance. If that happens, our economic problems will become much worse than they need to be, and our social problems will multiply. Only if we heed the lessons of the boom can we keep the bust from causing lasting damage. [Emphasis added.]

Sweet dreams.

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