WEEKLY ECONOMIC ANALYSIS: May 8th, 2009

Provided by TEAM Financial Services

"To combat a depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection- a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end."
- Fredrich Hayek - 1933

Items for Discussion

The announcement Thursday of the much anticipated (at least by we financial geeks) “stress test” results of 19 large US banks provided a clear signal as to the strategy being implemented by the federal government to try and “save” the banking system. The chronology of the plan is as follows:

1. Infuse massive taxpayer funds and guarantees to prevent a run on banks 
2. Use Federal Reserve Policy to rig interest rates so that even the worst banker can make money hand over fist
3. Pressure accountants to change accounting rules to allow banks to carry assets on their books at fictional values rather than market prices
4. Create a charade called “stress testing” using rigged assumptions based on fake accounting values with the hope that investors will buy the results and bid up bank stocks enough to allow them to issue stock and raise capital
5. Keep interest rates rigged long enough and allow banks to maintain reckless leverage so that banks can rebuild their capital and “earn their way” back to solvency

While these characterizations may come off as a bit harsh, this is precisely what we believe what has been and is occurring. For example, prior to the now infamous change in leverage limitations in 2004, investment banks were limited to 12-1 leverage. The current plan allows leverage of 25-1. Yes, after all of the reckless leverage and behavior by banks, the federal government is not only allowing but encouraging more of the same reckless behavior! 

TEAM believes this is one extremely dangerous game that the government is playing. They are relying on two major things that they cannot really control from remaining “in line”. Long term interest rates must remain relatively stable and the value of the US dollar cannot begin to decline significantly. These developments would jeopardize the government’s ability to continue printing money and rigging interest rates to bailout the banks. 

Government price fixing and intervention has a long and undistinguished track record of working temporarily and then ending in crisis. Markets can be interfered with and manipulated in the short and perhaps even the intermediate term, but ultimately the market will go where the market is meant to go. 

Two markets we monitor closely that are often off the radar of the average American are the bond and currency markets. In the past three weeks, 30 year treasury yields have moved from about 3.75% to almost 4.4% at their peak Friday morning. The US dollar has been clobbered against many currencies in recent weeks. I had an article published in the Harrisburg Patriot News in March in which I expressed that I had counseled my father-in law to convert his US dollars to Peruvian Soles ASAP. Since that time, the Soles has rallied by over 10% versus the US dollar. The Australian and New Zealand dollars are up over 10% versus the US dollar as well. The Canadian dollar is up over 5%. Commodity prices are up sharply across the board.

Many point to the fact that the US dollar has remained resilient, but they focus primarily on European currencies and the Japanese yen and not most other major currencies….and even most minor currencies. The move up in treasury yields combined with a falling US dollar is a toxic mix for the federal government’s charade. Their insistence on trying to prevent market forces from cleaning up the mess from the credit bubble has been greeted merrily by investors in recent weeks, but the long term risks continue to get larger, in our opinion. Policymakers continue to double down their bets hoping that eventually we’ll get back to even. While anything can happen, we believe the risks are tilted heavily against our collective success in the long run.

Market/Economic Climate 

Stock markets were very strong this week globally, though we were particularly pleased to see the Japanese market finally kick into gear. As mentioned above, the US dollar broke down badly this week, and we suspect it could be the beginning of significant weakness. This is one factor, along with good old fashion supply and demand, that plays into our bullishness on commodity prices. This certainly played out this week, as broad commodity indexes were up over 6% for the week. Precious metals stocks have also begun to act better and we believe they are now poised to resume their bull market trend.

The major stock market averages are now up just under 40% from the absolute lows hit intraday in early March. This is a historical rally, especially due to the complete lack of corrections along the way. All temporary dips have been bought aggressively by investors desperate to hop on the train before it leaves the station without them. We’ve been expecting a correction to emerge and that has been flat out wrong for the past month, as prices blew through our initial target area for resistance. 

Prices have now launched into our next target area, so we are once again cautious in the near term. Negative divergences continue to grow, as momentum wanes and leadership narrows. We moved Friday to reduce client portfolio risk further and now believe we are relatively well positioned to weather a correction of significance. Markets have reached rarified air and are in jeopardy of hitting a big air pocket to the downside, in our opinion. 

Humor for the Weekend 

This graphic comes via the Big Picture Blog authored by Barry Ritholtz.

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.