Under the Threat of Recession, The FED Will Likely Cut Rates!

``For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.”-Ben Bernanke, Chairman US Federal Reserve, On Milton Friedman's Ninetieth Birthday

With a slowdown in earnings growth, stubbornly high energy prices and a potential slackening of US economic growth (recent 3.4% could simply be a bounce), it becomes doubtful for jobs creation to pick up and weightlift its economy out of its present junctures. In short, the recent adverse reactions in the financial markets increases the likelihood of risks for a serious potential headwind; a RECESSION in the US, a development which we have been concerned with since last year.

In essence, the risks prospects that the US financial markets will possibly live through extended periods of downside volatility in the light of the changes in investor’s expectations as reflected in the credit markets as well as the recent re-ratings in the equities market seems accelerating until proven otherwise.

Since the US markets has reasserted its leadership role for most of the global equity asset markets, then the possible persistence of market turmoil could likely be transmitted into the global markets including that of the Phisix, as recently countenanced. We should then extrapolate such development to our portfolio by keeping ourselves judiciously in a defensive mode rather than wishing away our optimism. Remember no trends go in a straight line.

In the meantime, while the US dollar’s bounce was said to be a “flight to quality”, the stark manifestations in the credit markets are unlikely to herald “quality” with respect to US fixed income assets being the catalyst for the recent market deterioration.

What could be construed instead is that the US dollar has simply “bounced off from its record lows” following a test on its critical 35-year support level or in short, a plain vanilla TECHNICAL REACTION. Yes, US treasuries prices sharply rallied or yields declined, but this implies economic weakness (main window), as shown in Figure 5.

Figure 5: stockcharts.com: 10 Year treasuries, Oil

US sovereign securities (upper pane above main window) as measured by the Morgan Stanley Dean Witter U.S. Government Securities Trust served as a recent shock absorber to the recent carnage. Yet, this brings us to the implied message.

As we have discussed in the past, if the US equity markets undergoes further selling pressures, or possibly the Dow Industrials infringe on 12,600 or a correction of MORE than 10%, then we submit to the position that the US FEDERAL RESERVE will respond in a typical fashion when faced with ALL previous crisis: the provision of liquidity stimulus by the LOWERING of interest rates. It is thus said that a US recession induced bear market could translate to a loss of over 40% of market value!

The US Federal Reserve will most probably risk the destruction of its currency than live up to the risks of a debt induced deflationary recession that which is politically unpalatable.

And importantly, should losses exacerbate in US dollar denominated assets, this could also prompt foreign investors to look for alternative avenues to park their investments. In short, given the present circumstances the US dollar is unlikely to function as a safehaven.

To take a little gloom away; on the other hand, if the US markets manages to hold off at the said levels and consolidate then we are likely to simply experience a normal healthy corrective phase. But present market signals do not appear to validate this view yet.

Meanwhile, deflation proponents argue that monetary responses by the US authorities will prove to be inadequate this time around to save the US economy. Maybe so. However, given the reaction of the oil markets amidst the current upheavals, which even surged by 1.6% to $ 77.02 per bbl (WTIC-see Figure 5), it would appear that if the US will undertake inflationary measures via more expansionary policies to stave off what it frets most, some assets are likely to benefit from it, which leads us to a conjecture that precious metals would most possibly surge.

If the recent market actions in our Phisix should be an indication, then the mining sector was the least affected down by 2.56%. This, in contrast to the Phisix, which was down 5.87%, led by the Property sector (-8.3%), Holdings sector (-8.22%), Industrials (-6.52%), All shares (-5.73%) and the Financial Sector (-5.04%). Another bizarre development was the unfazed FTSE Australasia gold index which was unchanged over the week, compared to its counterparts which took the selling brunt as gold prices recently were equally slammed by the US dollar/Japanese Yen rally.

Lastly, with Asia, oil producers and emerging markets holding MOST of the world’s foreign exchange reserves and could probably be the LEAST exposed to the highly leveraged financial dominion of structured finance and derivatives compared to most of its developed market counterparts, it is likely that “quality” could instead be found within its asset markets.

As such, it won’t be a far fetched idea for global investors to get a whiff of this, and migrate financial flows or the genuine “flight to quality” which should cushion these markets from external selling pressures and prompt for these markets to delink or decouple from the US.