The U.S. Rate Slash Shows Things Are Even Worse Than Assumed

Includes: EWH, FXB, FXE, FXI, SDS
by: Enzio von Pfeil

Buy into weakness or sell into strength? This depends on what you think the 50 basis point Fed Fund rate cut will do to the economy.

1. Nothing

The excess demand for money remains on account of the simple observation that banks don't want to lend. Full stop. Lowering the price of money won't help: it cannot alleviate banks' leeriness of dodgy and murky credit risks whose magnitudes even the best financial brains cannot measure.

2. What we said on 10th September

Here is what we wrote on 10th September when we updated The Economic Clock(sub req.) for America:

The Economic Clock™ for America points to a bumpy road ahead. Over the past year, we have moved the arms of the Clock from "strong sell" to "Sell". We are going to keep this recommendation, but in the near term are happy to expect the Fed to start easing by Christmas. Sadly, however, easing will be short-lived, so do not pile into a sucker's rally.

The reason has everything to do with cost-push stagflation. Unit labour costs are rising 6x faster than when they bottomed. Besides, with US Congress badgering China so viciously, US import costs have to rise because Congress wants the RMB exchange rate to strengthen, and Congress wants Chinese manufacturers to adopt more disciplined quality controls. We have no problems with this - but wonder why Americans themselves cannot test what they are buying before selling it to their own countrymen? Whatever.

Amazingly, Congress wants the "Made in China sale" to end in order to make American workers pay higher prices. Another force depressing the dollar on a structural basis is that superpower currency must disintegrate (sub req.).

The bottom line is that while short-term demand pull inflation is abating, that will lead to some Fed easing. But, expect cost-push stagflation in 2008, meaning that the Fed cannot just keep cutting rates: the sub prime mess and a looming credit card crunch will exacerbate the excess demand for money.

So, from a profits perspective, corporates either pass higher import as well as unit labour costs on, irking the Fed, or they absorb these themselves, reducing their margins. Either way, US profits have a long way to fall thanks to slower turnover and wilting margins. So why buy the market? We are reckoning with a crash this October...

3. Some more current points worth raising

A new US import from China: inflation. We are in good company arguing that the future of inflation is up, not down. Alan Greenspan, in his memoirs, has said the same thing. In particular, he has alluded to inflationary pressures coming from China (even if his reasoning is curious): we can thank the US Congress for rising import costs from China!
A steeper yield curve.

4. How to make money off this idea

1. Always consult with your financial advisor before taking any action!
2. Go short the US market: the current ebullience cannot last long.
3. Go long China and Hong Kong.
4. Go long the Euro and Sterling: US rates are 50 basis points, or 10% less attractive than before (i.e. the cut from 5.25% to 4.75%), and as a superpower currency, the dollar has to continue weakening.
5. Short long bonds: stagflation is going to drive up long yields.