We expected an Election Correction once the Demo's won Congress - the reverse of what happened in 1994 when the Repub's took Congress. It is now occurring, but with a marvelous twist: it is first occurring in the Dollar in a reaction to Bush, not the Democrats. The 'good' Republicans in 1994 and the 'bad' Bush in 2006 may turn out to bookend the period of growth and bubbles in the US. We have undergone a great monetary experiment by the Fed during this period, and have seen the Chinese emerge on the world economic stage through 'vendor financing' of the US trade deficit. Let's take a look at this story and project out what happens next.
The story begins in 2001 when Greenspan dumped massive liquidity into US markets to avoid the deflationary depression that usually follows a stock market crash. This was conscious policy and meant to correct a great mistake of the Fed in the 1930s. We have been watching this story and have commented on it in a number of prior posts, including here (Beating Kondratieff Winter), here (the Greenspan Put) and here (the Greenspan Indian Summer). The resulting Greenspan Indian Summer has kept the market going when many pundits thought it would collapse. In one of his final columns, Milton Friedman in the Wall Street Journal compared three market crashes ('29. '89/Japan and '00) and showed that monetary policy caused the resulting financial problems. In the '30s, the Fed let the money supply (credit) collapse, and we had the Great Depression. In the '90s, the Japanese let it go flat, and they had their flat economy for 15 years. In the 'Oughts, Greenspan pumped massive liquidity, and the US economy suffered a light recession and kept on truckin'. At this point we should declare victory for Greenspan's policy, and expect Helicopter Ben to continue it.
What we don't know is whether Greenspan cured the problem or merely postponed the inevitable. The Austrian School of Economics would say, after an excessive credit boom (such as we had in the '20s and '90s, and Japan had in the '80s), we should take the medicine and get the resulting recession over with quickly. Otherwise the collapse is merely postponed, and made steeper. Instead, the US went from a stock bubble to a real estate bubble. The excess credit of the '90s rolled over to excess credit in the '00s, and the asset of choice switched to real estate. Obviously the US real estate boom is over, and seems to be rapidly unwinding with no end in sight. Although the perky financial press is calling for a soft landing, the inverted yield curve, slowing economy and real estate bust are all signaling recession ahead.
Greenspan's liquidity had the immediate negative effect of the Dollar dropping 30% over three years) against a basket of major currencies. Gold soared, as did commodities, and the Dow. On a Constant-Dollar basis, the Dow rose less than the Dollar fell, and is actually not that close to all time highs in real terms.
The potential distortions of the Greenspan Indian Summer also spill over into globalization. The US has been running an unprecedented trade deficit. In the past such a sizable deficit (approaching $1T per year, or 8% of GDP) would cause the currency to collapse. Instead the Chinese have been providing a form of 'vendor financing' by keeping their currency artificially cheap. They build up US Dollar reserves from all the sales to the US, and then buy US treasuries, which keeps the Dollar bouyant and the US Federal deficit funded. At some level does it hurt us to send over pieces of paper and get back physical goods at low prices? If the pieces of paper become worth less by the Dollar dropping against the Chinese RMB, the Chinese take an enormous paper loss and we get lots of new toys. Sounds clever, but it is too clever. It does cost us. The coming drop in the Dollar will reduce our national net worth relative to China. On the one hand it looks as if China is funding our deficit; but on the other we are funding the growth of their economy. If we had done so as we used to by investment, we would accrue ownership of major parts of the Chinese private sector, and reap the benefits of these investments as we had previously in Europe and other parts of the world. Instead we have reaped our transient toys, and they have reaped a marvelous and robust economy.
The Chinese are beginning to withdraw that vendor funding. The Chinese currency has started to appreciate against the Dollar, and China is diversifying their reserves out of the Dollar into a basket of currencies that reflect their trade flows. The YE$ currency is emerging. The Dollar is still the major currency, and is over-represented in such a basket due to seniorage we receive for the world oil trade being in Dollars.
All of this didn't seem to matter as we came into the mid-term election. The view that a split-government would emerge was positive to the stock market - a look back to history shows the financial classes are better off with divided government. When one party controls too much, regardless of whether it be Demo's or Repub's, spending gets out of control. Demo's get blamed for tax-and-spend; Repub's for borrow-and-spend. As the late, great Milton Friedman pointed out, the problem is spending, however financed. Bush turned out to be as profligate with other people's money when his party (Repub) controlled Congress as had Lyndon Johnson when his party controlled Congress (Demo). Both also made one of the classic blunders - getting the US stuck in a land war in Asia. This inevitable political tragedy regardless of party has substantiated the wisdom of the Founders of the US - the problem is government, and it has to be constrained. One couldn't count on either political party to be responsible despite all their high-handed rhetoric. Unfortunately, after the Great Depression, most of the Constitutional constraints on the Federal government have been eviscerated, and government spending in the US has accreted to over 40% of the economy across all levels of government (local, State, Federal).
The Election Correction did not happen when the Demo's won Congress in part because of the benefit of divided government, and also because this new lot of Demo's are much more conservative than the Demo's of the '60s and '70s who had let the economy get out of control before Reagan fixed it. Further, investors respect the job Rubin did as Treasury Secretary under Clinton, where he kept spending constrained and managed a robust economy adroitly. It was (and still is) hoped that the new Demo's will follow Rubinomics. After all, once the Repub's gained the House in 1994, Clinton triangulated towards the political center, respecting the message the voters had delivered - and became a better 'Republican' President than the Bush before him and Bush after!
But last week a series of events changed everything, and the Dollar plummeted:
- While the new rank and file Demo's are conservative, the leadership isn't - and they will drive the agenda. This began to become clear as infighting among the Demo's led some to publicly repudiate Rubinomics. What stripes they really wear will not become apparent until January. Hence the stock market has gone into a triangle - a holding pattern if there ever was one - and is likely to stay in it pending clarity on the direction of the Demo leadership.
- The Chinese RMB began appreciating, and the Chinese made public statements about their having too many Dollar reserves.
- Most devastating, Bush began making pugnacious speeches, starting in Vietnam and continuing in Jordan, to the effect that he doesn't give a damn about the message of the voters and will do what he damn well pleases with respect to Iraq. He even pre-emptively repudiated his own commission on the war, which is led by a trusted advisor to his father, James Baker, who was Treasury Secretary under Reagan. We don't know if he is posturing on the grand stage to get air cover for a shift on Iraq - a face-saving way to leave - or if he really intends to stubbornly oppose the growing pressure on him to get out.
Bush's behavior is quite unprecedented in US history, and the opposite of what Clinton did in 1994. It is certainly not a very smart move, because it rapidly makes him politically irrelevant, and emboldens the Demo's to begin 'investigations' to tie him down for the next two years, as the Repubs did to Clinton when they impeached him for diddling with an intern, or the Demo's did to Reagan for Iran-Contra, or what they did to Nixon for Watergate.
Worse, even the prime minister of Iraq felt he could snub Bush, by skipping a planned dinner a couple of days ago. The prime minister was under pressure not to meet Bush at all, and did the snub to appease his own political constituents. A remarkably bold dissing of a standing President in the middle of a war! He simply sees Bush as less relevant to the future of Iraq than all those militias and gangs he is warring with internally.
Now the financial markets need to deal with a lame duck President who might begin flailing away to maintain his stature, and in the process seriously damage US relations with our trading partners.
No wonder the Dollar dropped so sharply - it reflects a vote of no confidence in US leadership.
While we may want Bush's dad to take his son out to the woodshed and knock some sense in him, the dad has tried as much as he could by surrounding his son with seasoned and mature advisors. But his son seems determined in some twisted Oedipal plotline to make up for his dad's perceived failure in the First Gulf War by ignoring those advisors and continuing on his own path. How this will turn out is very murky. Murkiness is not good for financial markets.
Hence we end up with the Dollar on edge and the stock markets in a trading range unwinding as a triangle. Likely to sputter on until January.
Both Prechter and Neely expect the Dollar to reverse any moment. Whether this would be a brief countertrend rally or more than that is unclear. Prechter made a fine call 2 years ago December when the Dollar bottomed after a 30% drop from 2002. He sees us as now ending a B wave with a C wave up to Dollar Index 100 (from 83) over the next year. Yet the Dollar is skimming on the resistance levels that if it busts through make it more likely it will sink another 30% for an amazing 50% drop since 2002. Watch this closely over the next week.
Neely made two urgent alerts today - to be ready to short the S&P, and to get out of the Euro and back into the Dollar. He sees stocks as beginning a sharp decline, and the Dollar as solidifying. These may be short term moves, however, following oversold conditions.
The Fed is likely to ease in December, or January, given the deteriorating economic news. The bond market already anticipates this, and the bond bulls on this board have made some fine profits in the last few weeks. Indeed, the long bond has been in a trading range around 4.5-5% for a number of years, even while the Fed dropped the Fed Funds rate down to the bargain basement and then ramped it back up. Hence expect any Fed easing to have little impact on this larger picture.
In the end the US has very few levers left to pull if the economy sinks into recession. At best they postpone the inevitable through the 2008 election, and dump the recession on the next President. It is looking more likely, however, that the chickens come home to roost in 2007.