Initial unemployment claims in the U.S. unexpectedly fell below the 400,000 mark last week. While that’s welcome news, the current uptrend is still intact, and we won’t know if it’s been broken until September-October (do we break below the spring 2011 lows?). We’ll also need to watch the January-February numbers closely (does the trend of falling highs from the January 2009 peak continue?).
While the consensus answer to both of those questions seems to be “yes”, we remain skeptical. The U.S. yield curve remains steep, normally a positive sign, but one that we believe has little relevance going forward, based on Japan’s experience (admittedly an almost irrelevant sample of n = 3, but it makes plenty of sense in our macro framework). Most other indicators—notably in financial markets, fiscal/sectoral balances, and employment—are flashing bright yellow at the moment.
Yields, spreads, and prices of default protection on sovereign debt in Europe and China are blowing out.
Europe’s current policy approaches can’t possibly work without causing a recession or worse, and the eurozone economy appears to be on the threshold of recession. While this will be a rude but well-deserved awakening for the ‘core’ of France and Germany, it has the potential to cause Lehman Brothers- and AIG-like shockwaves across global financial markets. And if Europe’s various policymaking bodies dither at all (a high probability event), it could very well tip the global economy back into recession.
Although not widely discussed, it appears that the financial systems of China and some other important emerging economies are in a fragile and vulnerable state. Any shocks in these markets would also have a negative impact on world financial markets, and contraction in any key emerging market economies would also be quite detrimental to the rest of the world.
In the U.S., despite some heroic efforts, state and local governments fiscal positions are deteriorating sharply, which has historically been a harbinger of recession:
Temporary hiring may be starting to roll over, a phenomenon that preceded the last two recessions (another admittedly small sample) by less than a year:
Second quarter earnings season has included several mass layoff announcements from major U.S. companies. Although few are likely to shed any tears over it (even though a recent article from The Atlantic argues that it’s cause for concern), the financial industry is being particularly hard-hit. The July Mass Layoffs Report from the BLS, due in late August, will be an interesting read.
And of course, the debt ceiling debate rages on in the U.S. Congress. A book could be written about the severe errors being made on all sides*, but for now, an excerpt from a recent email to our clients should suffice:
(1) The issue is a red herring or straw man that distracts policymakers from actual issues like unemployment. It’s important to understand that every dollar the government receives in taxes or in debt auctions was previously spent by the U.S. Treasury (or in unusual cases, created by the Federal Reserve to buy something other than outstanding Treasury debt). So the President and House Speaker’s recent comments that the U.S. could ‘run out of money to pay its bills’ is utter nonsense. The primary purpose of Treasury debt is to provide holders of U.S. dollars (including China!) with an equivalent asset that pays interest. That’s it. And the rest of us cannot save unless the entity that creates the money that we save is running deficits. Until inflation starts to take hold (as opposed to relative price movements, such as higher commodity and lower home prices), there are far more important things to worry about, such as unemployment and household balance sheets, than federal budget deficits and ‘debt’ (dollars are a debt of the federal government too; to be consistent, the deficit-phobes should say that our grandchildren will have to pay them all back too; they don’t, which leads to the conclusion that they are utterly inconsistent). Reading between the lines (market action, comments from certain pundits and politicians), it sounds like a deal is close, and that both sides are jockeying for the most favorable position going into the 2012 elections (the GOP wants a shorter-term agreement in order to create a distraction for the president and his party during campaign season, while the Dems want to extend further in order to prevent that). It’s pretty astounding that our political leaders would risk so much for election strategy, but that’s our system at work.
(2) Treasury Secretary Geithner has issued other deadlines for default before the current August 2nd one, and they’ve all been wrong. Besides his credibility starting to wear thin, this means that there may be more time to strike a deal without adverse consequences (an analysis released yesterday by a Wall Street firm makes this argument, though I’ve only seen the headline at this point). A recent Reuters article also made the point that a ‘default’ would require some serious IT programming by Treasury, as most of its payments are automated (it is the largest single daily transactor in the global marketplace). This sort of proves the point above about Treasury spending first and “borrowing” later (though few people have picked up on it), and implies that at least some payments would continue for a time if an agreement on the debt ceiling isn’t reached.
(3) As lousy as the consequences at home would be, the most significant impact of a U.S. default or the agreements currently under discussion will occur abroad, notably in the emerging-market darlings of the past ten years, especially those who (a) rely on purchases from the U.S. and (b) carry external sovereign debt in U.S. dollars. In other words, any entity that owes U.S. dollars but doesn’t have the power to create them will be at risk (obviously, this will put a lot of U.S. households at risk too)…
…[These (Europe, the U.S., and China and other key emerging markets)] are the big secular themes at work, and as noted at the outset, there are no secular positives at the moment. That’s an unusual and very dangerous development for investors.
This is the most dangerous and unbalanced macro environment that I have witnessed in my investing career. As Warren Mosler recently put it, “I’ve never seen this kind of systemic risk looming in my 40 years in the financial markets.”
Keep your seatbelts fastened and eyes on the road ahead.
* Despite appearances, almost every single member of Congress (and policymaker in Europe!) believes in the same highly questionable macroeconomic principles, specifically the loanable funds market and the intertemporal government budget constraint [pdf] in a fiat monetary system. This means that despite the rancor and election-related jockeying, we are actually witnessing an episode of massive ‘mimetic isomorphism’ or herd behavior. And in complex adaptive systems like financial markets and economies, such behavior dramatically increases [pdf] the risk of severe dislocations.
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