Slip Sliding Toward Recession

Good day… The dollar continued its steady climb up versus most of the currencies yesterday in pretty slow trading. With no real data released yesterday, the range trading continued. But today we will see third quarter GDP, personal consumption, and GDP Price index along with the weekly jobs data and the leading indicators for November. Should make for a more interesting trading day, so let’s get right to it.

Economists believe the U.S. GDP will show a gain of 4.9% for the third quarter of 2007, the most in four years. But before everyone gets all lathered up about this strong growth number, most believe the third quarter was a one time surge, and these same economists predict the fourth quarter growth will slow to 1% and stay there through the first half of 2008. These third quarter GDP figures are obviously a look in the rear view mirror, so I think the markets will be more interested in the leading indicators number, which will be released later today.

The index of leading economic indicators likely fell for the third time in four months in November, signaling an increasing risk that the United States is ‘officially’ slipping into a recession. I highlighted ‘officially’ because, as most of you know, we believe the United States is already in a recession, which will continue to deepen. But now even the official numbers are showing the slowdown. The Conference Board’s gauge, which points to the direction of the economy over the next three to six months, is expected to have fallen 0.3% after a 0.5% decline in October, according to the median forecast of economists.

The deepest housing slump since 1991 is likely to worsen as foreclosures mount and banks restrict lending, economists said. Declining property values and rising energy costs may also hurt consumer spending, which accounts for more than two-thirds of the economy. A six-month decline in the leading index from 4% to 4.5% at an annual pace is one recession signal, according to Conference Board economists.

Former Treasury Secretary Lawrence Summers said it’s ‘quite likely’ the U.S. economy will fall into recession next year and urged policy makers to strengthen efforts to safeguard growth. Summers, who is now a professor at Harvard, is pressing the Bush administration to take further measures to contain the worst housing slump since 1991. “It is almost certain that we are headed for a period of heavily constrained growth” and “quite likely that the economy will experience a recession,” Summers said. He added that it’s “distinctly possible that we are headed into a period of the worst economic performance since the stagflation of the late 1970s and recessions of the early 1980s.”

Yes, he brought up the dreaded word: Stagflation. I found out yesterday that due to problems with our email server, several of you didn’t receive the Pfennig on Monday. That is unfortunate, as I think it was one of my better efforts! I would encourage any of you who didn’t get a chance to read it to check it out. I bring up Monday’s Pfennig because in it, I talk about the likelihood that our economy is slipping into Stagflation, and I have a long excerpt from John Mauldin’s weekly newsletter, which addresses this issue.

The United States is now facing the risk of both recession and faster inflation. The U.S. housing slump, coupled with a tightening of credit by banks has brought the world’s largest economy ‘close to stall speed,’ according to former Federal Reserve Chairman Alan Greenspan. At the same time, rapid growth in China and other emerging markets is driving energy and food prices higher worldwide. The injection of huge sums of liquidity into the markets over the past few weeks is also inflationary. How central banks react to this dilemma will determine which danger proves to be the biggest. For now, traders in the futures markets are betting the Fed will remain focused on supporting growth, even after the latest government inflation reading last week showed that consumer prices are rising at the fastest pace in more than two years.

The European Central Bank is also trying to stave off both inflation and a credit squeeze at the same time, and will soon have to choose sides. ECB’s President Trichet warned yesterday that high prices would persist longer than expected and that the bank stands ready to raise borrowing costs if necessary. Right now, it looks like Trichet will continue to pump cash into banks while holding its rates at a six-year high to restrain inflation.

While the ECB looks to be maintaining their hawkish tilt, the Bank of England is clearly on the side of supporting growth at the risk of higher inflation. This policy has caused the pound sterling (GBP) to fall below $2.00 for the first time in three months. The speculation is that the BOE will now continue to cut interest rates to protect growth. Minutes from the December meeting were released yesterday and showed that all nine policy makers voted in favor of the cut, the first unanimous decision for a reduction since the aftermath of 9/11. Policy makers considered a bigger rate reduction, but decided against it because it ‘would increase the upside risk to inflation,’ the minutes said.

The pound is ‘taking a pounding’, and with the BOE looking to continue to cut, we will likely see the pound continue to fall. I would suggest owners of pound sterling to look to move their holdings into other European currencies such as the euro (EUR), Norwegian krone (NOK), or the Swiss franc (CHF).

Japan’s central bank left its super-low interest rates unchanged for a twelfth straight meeting Thursday, amid growing worries about the health of the global economy. This non-move was the first unanimous decision since June and was widely expected by the currency markets, which see little chance of a rise before mid-2008. Japan’s economic growth has fallen short of the market and government expectations this year due to slowing business investment, a housing slump and falling exports to the shaky U.S. economy. It has taken longer than expected for Japan’s economy to exit deflation and falling consumer prices. Their core consumer prices rose for the first time in ten months in October, edging up 0.1%. While the BOJ interest rate decisions definitely have an impact on the value of the currency, ‘carry trades’ seem to be even more important to the yen (JPY). I expect the yen to continue on its recent roller coaster path of downhill slides when the carry trades go on and increases when these trades get reversed.

Chuck sent me a story that caught his eye yesterday. (Yes he still reads the financial papers during his vacation!) China’s state run investment arm, China Investment Corp. announced it was investing $5 billion into Morgan Stanley. This caps a year in which Chinese companies and the government bought more overseas than foreign buyers have invested into China. In Chucks words: “Soon… Nothing will belong to U.S. stockholders… China and the oil countries will own it all. They’ll own it all I tell you! AAAAAAAAAHHHHHHHH!”

Speaking of China, the central bank raised interest rates for the sixth time this year to cool the world’s fastest growing major economy after inflation accelerated at the quickest pace in 11 years. Before we get a ton of calls from investors in our Chinese renminbi access deposit accounts, we still can’t pay interest on these accounts. The Chinese renminbi (CNY) is a restricted currency, and is only available as an NDF (Non deliverable forward contract). The cost of these contracts keeps us from being able to pay interest on the renminbi access accounts.

But you do still get the appreciation of the Chinese currency in these accounts, and the renminbi rose for a third day against the dollar yesterday. The renminbi rose as the U.S. Treasury refrained from naming China a currency manipulator in its semi-annual review of exchange rates. No surprise here, as Treasury Secretary Paulson said that while the Chinese do keep their renminbi artificially low by selling them in the markets, this can not be seen as currency manipulation. Let’s get this straight, the Chinese are selling renminbi to buy U.S. Treasuries, and some people actually expect the U.S. Treasury to label them as manipulators? No way! There is absolutely no way the Treasury department is going to label the Chinese as currency manipulators, we need them to keep up their purchases of U.S. Treasuries!

Currencies today: A$ .8596, kiwi .7554, C$ 1.003, euro 1.4323, sterling 1.9878, Swiss .8635, ISK 64.10, rand 6.9985, krone 5.61, SEK 6.5946, forint 177.30, zloty 2.526, koruna 18.38, yen 113.23, baht 30.65, sing 1.4618, HKD 7.8015, INR 39.545, China 7.3694, pesos 10.8424, BRL 1.8048, dollar index 77.58, Oil $91.76, Silver $13.995, and Gold… $798.15

That’s it for today…Only four more shopping days until Christmas! I am sneaking out of here today to take care a bunch of running around. No birthdays today, but we still have leftover cake for breakfast! Hope everyone has Totally Tremendous Thursday.

Chris Gaffney
December 20, 2007