The Fed cut provided a nice boost to the markets, especially commodity names, cyclicals, and technology. Now, obviously there was a fair amount of short covering on this rally, but there also seemed to be some genuine buying.
I enjoyed this as much as anyone. But I did not like the big moves up in the basic materials and the big move down in bonds. I also was not impressed with the move in financials. The problem I see potentially looming is stagflation. There, I said it, stagflation - like we last saw in the 1970s and early 1980s.
The economy is on the brink here. The Fed admits as much with their 50 b.p. cut. A rate cut takes a few months to filter through and in the meantime, business spending and (to a lesser extent) consumer spending may slow further in anticipation of a recession. Adding to the problem is real inflation caused by the weak dollar. We are a huge net importer and a weak and weakening dollar means we are effectively importing inflation. The bond and gold markets are pricing this probability in quite aggressively.
Should we enter into a recession in the next few months or if we are already in one, the emerging markets will implode, especially China. The collapse of China will cause our recession to be much deeper and prolonged. China would suffer greatly from a U.S.-led consumer retrenchment. Like it or not, they depend heavily on us to buy prodigious quantities of items to keep their economy humming. A U.S. recession would clearly derail their growth both from an export and investment standpoint.
Now, here's where it gets scary. China has been a huge supporter of the dollar through its buying of US treasuries. If China does get hit, our dollar will be in a world of hurt. That will send inflation soaring and there will be nothing the Fed can do. With our massive deficit, it will be a Herculean effort to convince the world they want to hold dollars. Maybe if rates go to double digits we will get some takers - just like the 1978-1981 period.
There are ways to make obscene amounts of money from this scenario, or even the possibility of the scenario. I am taking some of those steps now in my portfolio. If I were an oddsmaker, I would put a 25% chance on the worst case scenario, 50% on a milder variation, and 25% that we can pull out of this Greenspan-caused liquidity nightmare intact.
I think Greenspan really messed the economy up by saving LTCM, and trying to "soft land" the internet bubble by flooding the market with cheap money. That, however, is best left for another post.