Causes of an Unstable Market
So much for the relief rally.
After all the hand-wringing, grandstanding and political showmanship this past week over the debt ceiling, you’d think the Dow would be more grateful than the 145 pop it gave on the open this morning.
Alas, immediately following the open… it sank. As we write, it’s down 45 points.
The culprit? The ISM manufacturing survey tumbled in July from 55.3 to 50.9 — a two-year low.
To say the number violated the Street’s expectations is, um, an understatement: Among 80 economists polled by Bloomberg, the lowest guess was 52.0. Every component of the index indicated slowing growth… and new orders fell into outright contraction.
Whether Congress votes on this deal to raise the debt ceiling or not… there’s plenty of real concerns in the economy to give stock traders the willies.
Likewise, commodities traders are feeling a chilly wind. Manufacturing in China slowed for the fourth straight month.
The June figure of 50.9 fell to 50.7 in July, according to the China Federation of Logistics and Purchasing (FLP), the ISM’s counterpart in the Middle Kingdom.
Within the FLP report new orders look promising… mostly chalked up to domestic demand, not exports. But a separate unofficial gauge of Chinese manufacturing issued by HSBC slipped into negative territory.
Given comments we heard during the symposium last week, we expect an “official” decline in Chinese manufacturing… which, as we noted a few days ago , would drive down prices for the 11 commodities of which China is the largest consumer.
We’ll spare you play by play on the bipartisan deal making its way to the floor of both houses for a vote, possibly tonight. But here are a few cogent plotlines:
• The $2.5 trillion in spending cuts are, in the immutable logic of Washington, not cutbacks at all… but limits to the planned rate of spending increases
• Even better, they don’t don’t kick in until 2013. At that time, a new Congress will be in place, unbound by the promises of the current one.
There’s also a “last minute” mechanism by which $1 trillion of the “cuts” are to be specified now, while the remaining $1.5 trillion — including Social Security and Medicare fixes — are to be hashed out by a special 12-member congressional committee.
It gets better.
The committee will issue its recommendations by Nov. 23 — the day before Thanksgiving. Congress would then vote on the recommendations by Dec. 23 — the Friday before Christmas.
Even if this deal gets the votes it needs, the White House and Congress have done their best to give the can a good swift boot… but made only a glancing impact. The can will have barely moved.
Now the rating agencies face another challenge to their credibility. The big three have spent the last several weeks threatening to downgrade Uncle Sam’s AAA bond rating unless the deal actually gets spiraling debts and deficits under control.
“$4 trillion would be a good down payment,” said John Chambers, the head of S&P’s sovereign ratings committee. The number in the proposed agreement is $2.5 trillion.We daresay that if S&P wants to continue to attract business… it will have to follow through on its threat.
“Eventually, there’s a downgrade coming,” Pimco’s Bill Gross said yesterday. “It just depends on Moody’s, S&P and Fitch, and they’re very slow-moving. This country has $10-12 trillion worth of outstanding debt. In addition, however, we’ve got about $60 trillion worth of liabilities.
“I call this Debt Man Walking.”
“A downgrade from AAA is a matter of when, not if,” writes our short strategist Dan Amoss. “In it’s wake, the dollar index will fall and gold prices will explode on the upside. Such a downgrade would speed up a slow-moving process that has long been under way: the loss of the U.S. dollar’s role as the primary reserve asset for central banks.
“Even the most radical forecasts are off base.
“The Fed will have to ensure that there is no liquidity squeeze — perhaps even reopen the commercial paper funding facility it started after the Reserve Primary Fund ‘broke the buck’ in 2008.
“In short, foreign creditors should accelerate their diversification out of Treasuries and into tangible assets when even the slowest money starts realizing that the positive attributes of the Treasury market — liquidity — are far outweighed by the negatives — never getting repaid in honest money.”
Of the $2.2 trillion in revenue the Treasury pulls in each year, about 10% is going for debt service.
“We’ve had higher numbers before,” said veteran analyst Adrian Day on Friday during our symposium in Vancouver. “But rates are now at 70-year lows. And more of the new debt Treasury is issuing these days is of short duration… because those rates are lower.”
Just a reversion to “normal” interest rates… never mind a downgrade… would quickly drive up debt service to 30% of revenue.
This is a reality foreigners already recognize… which is why they’re buying fewer U.S. Treasuries. China’s Dagong rating agency gives its top ratings to Norway, Denmark, Luxembourg, Switzerland and Singapore. Among the world’s nations, Dagong ranks the United States No. 13.
If foreigners got serious about fleeing Treasuries, the heavy lifting would fall once again to the Federal Reserve. As yet, the Fed has already bought up 80% of Treasury debt issued in 2011.
“There’s something dramatically wrong when one arm of the government is creating money to buy the debt of another arm of the government.”
Amen, Mr. Day.
“This whole wrenching effort to shrink the debt may actually increase the debt,” explained an AP story anticipating a downgrade.
A downgrade “could increase the cost of borrowing for the government — hence more interest and debt — not to mention for everyone else.” Not the least of which are state and local governments who received 80% of the last round of stimulus.