The dollar was crushed yesterday. The U.S. Dollar Index dropped more than 2%, reversing whatever gains were left from the now-evaporated summer rally.
The verdict, it would seem, is in. The forex market isn't amused by the prospect of adding $700 billion-plus to the already bloated U.S. budget deficit. Jay Bryson, global economist at Wachovia Securities, summed it up neatly in a note to clients yesterday, explaining that "this weekend’s announcement that the U.S. government will buy up to $700 billion worth of bad debt from financial institutions is a short-term negative for the dollar. In order for investors to absorb the increased issuance of U.S. Treasury securities the returns on those securities will need to rise."
Bryson adds that there are two ways for bond returns to rise from a foreign investor's perspective. Yields can rise, which is to say that prices will drop. That seems plausible, given that $700 billion in new debt equates to roughly 15% of existing Treasury debt outstanding. The second way is a depreciation of the dollar.
Yesterday, we got both. The buck was slammed and the benchmark 10-year Treasury Note rose to 3.83%, the highest close in more than a month.
Why does this matter? Because foreigners will be ponying up a fair chunk of the $700 billion loan to fund the new bailout plan. As such, monitoring what foreigners think is more than a passing news story these days. One might wonder what might compel foreign central banks and offshore investors to further expand their already large holdings of Treasuries.
But all is not lost for dollar bulls. Some of the fall yesterday was a reflection that there are still lots of unknowns about when Congress will greenlight the money, and what the terms will be. As those gray areas lift, and if the market takes a shine to the details, the greenback may rebound.
Nonetheless, forex risk has jumped sharply in recent days. The U.S. was already tending a hefty batch of red ink before the events of the past few weeks. The federal government was in the hole for $162 billion for fiscal year 2007, according to the Congressional Budget Office. The good news: that's smallest pile of debt since FY2002's $158 billion. It's also the smallest share of U.S. GDP since FY2002 as well.
The challenge isn't looking backward, however. It's the future. A variety of storms look set to bedevil the U.S., and a $700 billion bill that dropped out of the sky is only the beginning. The CBO's baseline budget projections already called for a doubling of the budget deficit to $325 billion by 2011, as published on September 9. But a lot can happen in a few days, and back-of-the-envelope analysis suggests that given the latest bailout news we can boost the $325 billion deficit to $1 trillion, give or take. Oh, and by the way, that surge in debt is imminent, or so it appears.
Granted, your editor is no authority in the Byzantine ways of budget projections and so one might imagine that the green eyeshade boys will figure out a way to deliver a kinder, gentler statistical report going forward. One can take inspiration, if that's the right word, from the existing distinction for on-budget and off-budget appropriations, and related accounting tricks. In any case, the actual budgets and the degree they represent spending in excess of assets is always an adventure, and the future promises to bring no less.
But for those who worry about the dollar, and what it means for the U.S. economy in 2009, one could soothe nerves by considering the economic weakness that's bubbling in Europe, which of course houses the primary alternative to the little pieces of paper the U.S. Treasury signs off on. Indeed, the biggest economy in euroland is struggling, Reuters reports: "An end to the export boom that has long underpinned German prosperity leaves the country's economy, despite its relatively sound fundamentals, facing the prospect of several quarters of low or negative growth."
The U.S. has its own economic issues, starting with the outlook for consumer spending. It's unclear how Joe Sixpack will react to all the news on Wall Street of late, but it doesn't take much to imagine that consumer spending in the months going forward will be a tad weak.
If so, what might we expect for corporate profits? Or, to pose the question another and not-entirely unrelated way: How much will financial sector ills weigh on earnings generally for U.S. stocks? Only a handful of companies have reported Q3 numbers so far, and by that thin sampling there's mostly red ink. But for the yet-to-report majority, the bulk of the pain will come in financials, of course. Zacks projects that earnings will slump 11% in this year's Q3 for financials in the S&P 500. Other than a slight drop in earnings for consumer discretionary stocks, the remaining eight S&P sectors are all expected to report gains for the July-through-September period, leaving a 6.6% overall gain for S&P earnings.
"The S&P 500 as a whole is trading for 15.0x and 12.0x, 2008 and 2009 earnings, respectively," Dirk Van Dijk of Zacks wrote yesterday. "Based on a blend of 33% 2008 earnings and 67% 2009 earnings, that translates to a 7.71% earnings yield, which looks extremely cheap relative to a 3.80% ten year T-note. Even against the A-rated corporate bond yield of 6.30% it looks attractive."
In short, there's a case for continued nibbling at stocks, particularly for those investors with a long-term time horizon (five years plus) and U.S. equity allocations that are significantly underweight. But make no mistake: the unknowns are many, and their potential for surprising Mr. Market--both negatively and positively--are high by normal standards.
Still, sentiment is hurting and there are not a lot of investors who aren't already shell shocked. That doesn't mean that there's a bottom lurking around the corner. But for those who can wait a few years, the massive risk that seems to inhabit everything may not be so massive as it appears if we adjust by looking forward.
But in times like these, one can't ignore the unknowns. Ours is a moment of extreme stress, and for good reason. The frustration of investing is that it's always one part science, one part art. The weighting, however, is far from fixed and equal at any given moment. Let's simply say that there are a lot more artists running around in portfolio management these days.