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Painting Corners

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Please don't pick up that paintbrush Mr. G!

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As we stated in The Buzz, the weak PMI from yesterday was supported by the weak jobs report for June. The fact that the BLS plugs in an arbitrary birth/death small business number only reinforces this fact: without this plug number jobs actually fell by 70,000. Most of this decline was again in manufacturing jobs.

There are two schools of thought on this. The first is that this is just a slowdown in an otherwise healthy expansion. The second is much more disturbing.

Since 1987 the Federal Reserve has been using liquidity to prop up asset prices. This was the easy way out as there is these days little political will to do what is right (allow the market/capitalistic process to allocate capital to efficient resources and purge the system of inefficient ones) and possibly painful. The miracle of "no economic down cycles" was in actuality just a new coat of paint applied over and over. The layers of new paint are equivalent to new levels of debt, both public and private. This is evidenced by the fact that it takes six times the amount of new debt to produce a unit of GDP than it did twenty years ago.

The longer we see this type of weak data, and the fact that it accelerates every time the Fed takes its foot off the accelerator, the more the evidence leads to the second conclusion:

That the Fed may actually have to LOWER rates sometime in the next 18 months.

Unimaginable, you say?

The most interesting aspect of the macro landscape over the last 2 years has been how assets have led the economy. Stocks, commodities, corporate bonds: all pretty much bottomed in late 2002. The economy bounced several quarters later. This is typical in a hyper-liquid environment. The "real" economy does not have need for the excess liquidity that the world's central banks create. But the money has to go somewhere. So into assets it goes. And those assets see a serious inflation. Only after a lag does the real economy exhibit the results of that "Super Money" (a term Ed Yardeni has coined for coordinated central bank liquidity).

And since the beginning of 2004, the most striking aspect of the macro landscape has been how correlated the declines in assets' values have been: stocks, metals, commodities, corporate bonds. Is asset deflation leading a real economy deflation in 2004 like an asset inflation lead a real economy inflation back in 2002? It's too early to say at this juncture. But the macro data and the financial markets are suggesting it's a real possibility.

If indeed asset deflation does lead to a real economy deflation, then you already know that the statement we posed above: "that the Fed may actually have to LOWER rates sometime in the next 18 months" is not as unimaginable as conventional views would have it.

There can be no question that, faced with another bout of disinflation (or deflation), the Fed would lower rates. Aggressively.

What type of signal would this send to foreign holders of US debt? What type of signal would this send to the treasury market? To the stock market? To commodity markets? In our view, it would cause near panic.

For the last 18 months we have been racking our brains trying to determine a potential catalyst for the resolution to the untenable trends in the US debt markets, for the US dollar, to stock market valuations, to corporate bonds, to global macroeconomic imbalances.

If the Fed actually has to lower rates sometime in the next 18 months, that could well be the catalyst we have been looking for to ultimately resolve the unstable macro trends that pervade the world's economies and asset markets. This scenario is what we have been trying to educate Minyans on for the last 18 months.

We know the Federal Reserve wants to keep on painting and painting (expanding credit). Right now they have stopped. But if they are forced to pick up the paint brush again, the whole world could find themselves painted into a corner.
No positions in stocks mentioned.

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