Is Bernanke facing a death spiral?

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Thomas Hobson ran a thriving carrier and horse rental business in Cambridge, England around the turn of the 17th century. He rented horses mainly to Cambridge University students and was known for not giving his customers a choice as to their mount – it was simply “this or none”, i.e. Hobson’s choice.

Fast-forward to November 2007 and one cannot help wondering if the US economy has taken on the guise of a modern-day Hobson, really offering no choice at all. And on the receiving end is Fed chairman Ben Bernanke facing an increasingly recessionary economy. A worsening housing situation and the likelihood that significantly more credit losses lay ahead leave him with what Richard Russell (Dow Theory Letters) describes as a “brutal problem”.

Before digging a bit deeper into the alternatives available to Bernanke and the monetary authorities, let’s focus on the graphs of the Philadelphia Housing Index and Bank Index for a snapshot of the market’s assessment of these two intransigent sectors.

5-nov-1.jpg

Source: StockCharts.com

5-nov-2.jpg

Source: StockCharts.com

These are downright awful pictures and especially disconcerting because the stock market as a matter of course discounts the real economy by anything between six and 18 months. This in itself spells bad news for the outlook for US economic activity.

Should Bernanke and his cohorts drag their feet with interest rate cuts, there is more than a sporting chance of the US economy slipping into recession and dragging the rest of the world down. This will, in my opinion, unleash the forces of deflation with rather dire consequences, especially given the highly-leveraged state of the US economy.

On the other hand, should Bernanke throw increasing amounts of money at the problem and cut interest rates aggressively, the dollar can fall down a precipice. Inflating the economy out of its quandary, however, may be the only policy option with a chance of success.

This raises the question of how foreign investors are going to react to the trillions they have invested in the US dwindling in non-US currency terms. Anybody under the impression that US equities and bonds have been performing reasonably well this year must think again. The graph below shows the Dow Jones Industrial Index in both US dollar terms (red line) and euro terms (blue line). Whereas US investors are showing a return of 9.08% for the year to date, euro investors are in the red to the tune of -0.81%. (Although I am using the euro in this example, the same logic applies to most other non-US dollar currencies.)

5-nov-3.jpg

Source: StockCharts.com

The next graph illustrates the same principle for bonds by comparing the US Treasury Note Price Index in US dollar terms (red line) with the same Index from the viewpoint of a European investor (blue line). The results are as bad as for equities.

5-nov-4.jpg

Source: StockCharts.com

And for good measure, the hard numbers are summarized in the following table:

RETURNS FOR US STOCKS AND BONDS (US DOLLAR AND EURO)
Index Return
Year to dateAug 17 – Nov 2
- US dollar9.08%5.70%
- Euro-0.81%-1.89%
10-year US Treasury Note Price Index
- US dollar 3.23%2.70%
- Euro-6.13%-4.67%

Source: StockCharts.com

How much longer will foreign investors put up with a plunging dollar eating away at their returns? On the last count, the formation of 17 Sovereign Wealth Funds (or varieties thereof) have already been announced. It is an open question how much of these countries’ existing US investments will be redeployed to non-US dollar pastures through these entities. Somewhere down the line, a point will be reached where America will start offering bargains galore to the non-US dollar investor, but we may not have arrived at that juncture yet.

It is perhaps too early to conclude that Bernanke is facing a death spiral, but it would appear that he is confronted with the proverbial Hobson’s choice – inflate or die. With stocks still in overvalued territory and bonds looking equally toppish, this really leaves few investment avenues other than cash or gold (in whichever shape or form). Although gold may be overextended in the short term, it should remain the ultimate reflation / safe-haven play for the foreseeable future. That, at least, is the way I will play the markets until such time as Hobson reappears to offer Ben a few additional choices.

5-nov-6-p.jpg

Source: Jim Sinclair’s Mineset

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10 comments to Is Bernanke facing a death spiral?

  • Prieur, you have hit the truth on the head. The investment sales industry is always eager to give us buy ideas but most assets in the world are now suffering from the same diseases of overvaluation, low-yield, volatile currency exchange, and inflation. Sometimes the best thing we can do as investors is be safe and be still. When assets seem high-risk and low-reward, the rational response is not to keep picking from the dregs, the rational response is to withdraw and wait for more attractive valuations to present.

  • Thanks for visiting Danielle. I look forward to reading your book “Juggling Dynamite”. It promises to be a great read.

  • George [USA]

    Prieur,

    Just wanted to say “Thank You” for all the hard work you put into this web site. Although I am a novice investor I have learn a great deal from you. You help me see the big picture and to see it more clearly!

    Bless you for all that you have done….

  • [...] Damned if you do, and damned if you don’t: Should Bernanke and his cohorts drag their feet with interest rate cuts, there is more than a sporting chance of the US economy slipping into recession and dragging the rest of the world down. This will, in my opinion, unleash the forces of deflation with rather dire consequences, especially given the highly-leveraged state of the US economy. [...]

  • Sir: I agree with your statements; I have likened the situation to a dying patient on increasing doses of life saving drugs; usually at some point, the medications (or infusions of capital) just stop working. Are we at that point? It sure seems like it.

    For my own part, I have been calling a market top of significance for over 4 months now. You can see my latest insights at:

    http://www.greenfaucet.info/the-market/the-this-time-is-different-scenario

    Keep up the nice work

  • Ian Nunn

    As a neophyte, I understand how gold (or any other hard asset) is a hedge against inflation.

    I don’t understand what its role would be in a deflationary recession situation. I think conventional wisdom is sell assets and go to cash, buying them back cheaper after they deflate. However gold has a quasi-monetary role.

    In our current insecure USD environment, would gold hold its value under recessive deflationary pressure?

  • number2son

    Can’t argue with you at all, but as gold and silver reach new highs this morning I wonder if any of us will ever get a chance to buy on a pullback.

  • Sumeet Valrani

    I agree with Ian. How do we prepare for delfation? What does deflation mean – will the cost of food, consumbales etc. go down?

    Will India and China keep booming?

  • [...] language of the US stock market for the last few months, and more recently in articles entitled “Is Bernanke facing a death spiral” (November 5, 2007) and “Where to now, Mr Dow” (October 22, 2007). The fundamental picture [...]

  • Michael

    Quite Savvy timing. When they started the $41 billion dollar Fed Reserve “bailout” in August, the market sniffed the problem mighty quick.

    And the market tanked.

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