The credit market, at this point in history, is the most important factor in determining business activity, which in turn establishes the health of the labour market. On the other side, the credit market is integral in the housing sector, which not only has an effect on personal consumption and consumer confidence, but also carries a direct link to the asset values of structured debt instruments on the books of large financial institutions. It is easy to see how the borrowing and lending environment for consumers and businesses connect the pieces of the economy and how small disruptions in that market can have large impacts on broader economic growth. I don’t want to paint a doomsday scenario, but conditions exist today that could precipitate sub-prime credit woes to spread into so-called prime and upper-tranche level assets. Both the major North American auto manufacturers, as well as credit card giant American Express, have told us lately that customer defaults on credit obligations are showing no signs of abating. Leases may become a thing of the past because the values of the asset (SUV, truck, or car) are worth substantially less at expiration, which is affecting resale values of the assets and the ability of these companies to break even on such a transaction. American Express also warned in its latest earnings release that defaults on consumer debt remain high and spending by even the most affluent of consumers has begun to curb. Auto loan and credit card receivable structured debt is a significant portion of the CDO market and if weakness extends to these assets, as it so famously has with MBS, this may spark a whole new round of asset write-downs and fears of general economic weakness. Institutional buyers of these assets, commercial banks and financing companies would most likely feel the brunt of this pain as it spreads throughout the economy.
Mortgage lending remains very tense; as the combination of tightened credit standards and heightened inflation expectations have pushed up long-term lending rates. The Fed in its statement today tried as best it could to balance the need for real inflationary concerns with a watchful eye on risks to the downside as generated in the credit market. The Fed, through it’s policy instruments, can only affect the short end of the yield curve; however, through it’s hawkish rhetoric on inflation it has the power to affect future inflationary expectations of the bond market and thus, long term yields. The only thing the Fed can do at this point is to talk tough on inflation, and be vigilant on credit lending conditions and the health of the banking system. Hopefully time will mend the credit market, at which point the Fed can concentrate it’s efforts on restoring confidence in the long-term stability of prices. If things don’t turn out so rosy, meaning credit defaults spread and inflation is again put on the backburner… the sky is the limit for commodities, inflation and an all out crappy economy.
Interestingly enough, the stock market has responded quite positively to the precipitous drop in crude oil prices as of late. However, optimism should be met with great trepidation. The initial rally in equities caused by the price drop in oil was broad in nature and on very high volume; as oil has continued to drop, volume has dried up and some sectors have stopped responding all together. I think the market realizes that the increase in commodity prices came with a loosening of monetary policy; now, no catalyst exists to bring prices down to acceptable levels, except for the recently popular (and even more fragile) ‘demand destruction’ theory. The trend in commodities, as of now, seems to be broken. However, I foresee a consolidation at some level in the near future as traders run out of reasons to sell. Now if the dollar holds this temporary bottom and gains ground against other major currencies, this may be another mechanism to press down on commodity prices in general. With the ECB and the UK central banks convening policy meeting this week, they may favour risks to economic growth as inflationary pressures seem to be taking a back seat to surprising weakness in some of the more resilient eurozone economies (ie. Germany).
I would like to end this post with a short commentary on the possibility of the U.S.A. turning red. Yes, being a ‘greenie’ (or environmentalist) is a thing of the past; the new wave in popular American politics is socialism. Let’s review some of the recent events on both the political and economic fronts: FHA bailout legislation, government rebate stimulus package, Bear Stearns bailout, provisions and increased guarantees for Fannie and Freddie, restrictions on short selling and the popular support for regulating ‘speculators’ in oil futures. Add to this list the fact that the presidential candidate leading the polls is a severe left leaning liberal who publicly states that his economic platform revolves around taxation and redistribution of income. Mr. Obama’s latest stunt aimed at appeasing voters at the expense of free market economics is to tax oil companies and give the proceeds to consumers in the form of an ‘energy rebate’. The most surprising thing is that such a radical policy of taxing a private entity to support a social agenda would likely be met with support from the middle class who are largely uneducated on the dire consequences of such an egregiously disrespectful and socially irresponsible policy. Unfortunately there is not enough space on this blog for me to discuss the buffoonery of Congress, and specifically Nancy Pilosi, to adjourn to a summer holiday without even a vote on critical energy policy issues. It is a slap in the face to the voting public for elected officials to be so unproductive and subsequently complacent in the face of a national crisis. For the last word, I will digress to the wisdom and supreme importance of the Kudlow Creed…
"We believe that free market capitalism is the best path to prosperity"!
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