Forex Traders'  Instablog

It’s all good news once again for Wall Street, as corporate earnings releases beat about 80% of analyst expectations for the latest quarter. This is surely a remarkable record, and a reason for optimism. So is the skyrocketing productivity growth among U.S. firms, although that is often regarded as a bad omen. On the contrary, we strongly believe that rising productivity is the surest catalyst of long-term growth, whether it is caused by scared workers working harder, or by technological innovation. Naturally, in the latest bout of productivity rises, both of these factors play a strong role; firms invest more in technologies that help increase employee output, so as to get rid of as many of them as possible in an uncertain environment. Nonetheless, opportunities are born out of adversity, and there is little doubt that the flexible adjustment observed in the American economy is overall a benefit to the long-term economic health of the nation.

The real problem is the nature of the investments that go into productivity, what drives managers in the direction that they take, and also the role of contracting credit in the equation that will determine the future of American economic growth. Managers are probably not as optimistic as numbers show them to be on the basis of improved profitability and better balance sheets, because they are still discharging workers. They are unwilling to tap into their credit lines for expansion, and try to improve performance by contracting activity. What is more, the lifeline of the economy, the liquidity supplied by financial institutions, is continuing to diminish, and credit standards are still tightening overall, in spite of the massive easing that has taken place over the past two years. There are a large number of firms which have got a very big mess in their hands, with no visibility about how to get rid of it. The status of consumer credit, as well as industrial loans, do not provide any reason for optimism at this stage. It is easy to get distracted by noting improvement in sectors which were never the cause of the crash in the first place.

According to the latest reports, a $5 trillion federal budget is the optimistic estimate of the Census Bureau based on present spending patterns of the U.S. public sector. Yet, with not a single sign that the government is prepared to match its future expenses to its income, there is every possibility that the budget will keep ballooning to much greater levels than what is even being imagined today. After all, who would believe that we’d see a 3.5 trillion dollar budget in 2007? And these numbers do not necessarily include all the various costs associated with the myriad operations conducted by the Fed and the Treasury over the past months.

A few days ago the Treasury auctioned about $7 billion in five-year inflation-indexed securities (TIPS), and demand was robust. The bid-to-cover ratio, according to Bloomberg, was 3.10, highest since October 1997, signaling that investor appetite for government paper is far from being exhausted. Indeed, since TIPS ensure against inflation, they are probably even better than gold as a hedge against future volatility at this stage. If you don’t believe that the government is going to supply the dollar massively in excess of demand in order to meet its future obligations, and are confident that the exchange rate risk is manageable, TIPS provide a credible opportunity to hedge against volatility and uncertainty in the markets.

Notwithstanding the ever-present worry that the Chinese and the Russians, even the oil giants of the Gulf region may begin to run away from the dollar in panic at any moment, the dollar seems to be doing reasonably well against its peers, given how severe the deterioration of the U.S. finances are.

We have always been of the opinion that this recession will be w-shaped, with two dips as the effects of the economic stimulus packages recede, and investors and authorities alike come to the realization that we had been riding an air bubble all along this fake bull market. The non-farm payrolls data of last week only confirmed the suspicions of bears. The unemployment rate went up by another 0.1 percent, and the monthly payroll cuts exceeded the August number by 60000. Still, we caution against taking the shocking headline number too seriously however. The BLS has a habit of performing erroneous calculations in the month of August as youngsters leave the labor force to go back to school, and this distortion often causes swings and errors in the interpretation non-farm payrolls report in this season.

With speculation rife that the American economy has a bright future before it, the main question that awaits its answer is about the source of the oncoming recovery. When the last major recession of the 1990s ended, the following boom was fuelled by immense productivity growth enabled by computerization. Before that, after the Paul Volker-induced recession of the early 80s, the revival was financed by a large amount of government spending under the Reagan Administration, and the expansion of the debt stock of the country. The bust that followed the dot-com boom, of course, was ended by the easy-money policies of the Fed which fuelled the mortgage bubble, and its many mirror images in China, and the developing world.