Connelly on Commerce

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The argument between the financial markets and the Federal Reserve continued unabated early this week, marked notably on the first full trading day past Thanksgiving with a decline in interest rates on the 10-year Treasury bond to 3.80! (not to mention another 200+ point decline in the Dow). The markets either simply didn’t believe the Fed that the risks to the economy from inflation and recession are evenly balanced at this point (and that the Fed therefore proposes to maintain “neutrality” in interest rate terms with no further cuts short of a catastrophic, present-tense market event) or simply disdn’t't believe IN the Fed anymore  –  even if it cuts rates again in two weeks, it will be too little, too late to stop a recession by 08!

Fed officials, including Chairman Bernanke, were scheduled to speak publicly this week — probably their last chance before their usual pre-meeting “blackout” period to reestablish a sense of connectedness to the reality which the markets see, and perhaps also to  reiterate in the subtlest way their concerns about the effect of a depreciating dollar on their range of policy options.

As this blog has been noting all year, the Fed is caught in a dilemma: if it cuts rates to sustain economic activity, it invites a run on the dollar, higher oil and other inflationary pressures and expectations that would in turn call  for rates increases. Well into the summer it sought to avoid this trap with a forecasting view that the sub prime/credit crisis was ring-fenced away from the economy at large: a sort of ‘studied complacency’ that only served to convince many market participants that the Reserve Board itself was out of touch with reality.

That studied complacency appeared again earlier this month in post-meeting commentary by several Fed officials and to a lesser degree in the Fed vaunted new forecasting models, whic; which edged down their collective assumptions for growth and inflation into the coming year, as well as the model target for ‘sustainable’ GDP growth going forward. A company which put out a similar growth forecast for the coming next couple of years would have had it shares pummeled in the unforgiving equity markets. For the Fed, the market’s only recourse was   to test its lows  and punch through them to an “official” 10% correction on Monday.

It’s not that the markets do not recognize the inflationary risk in a battered dollar attributable to lower interest rates. The market is simply saying, with Scarlett O’Hara, that “I’ll worry about that tomorrow!… Today I’m worried about foreclosures, the balance sheets (and lending capacity) of banks, the staying power of consumers, not to mention election year mischief.”

The markets had only one weapon against Fed determined to hold the line — a Scarlett O’Hara swoon! And apparently Scarlett got her man (or men), as in successive speeches on Wednesday morning and Thursday evening the Fed Vice Chair and Chair both acknowledged the markets’ view of reality — namely, that things had changed for the worse in terms of incoming data since the Fed’s last pronouncement about evenly balanced risks of inflation and recession, and that the Fed would have to respond with “nimble” and flexible policy (translation — a December interest rate cut is on the table).

So it appears that the Fed will not let Scarlett go hungry this Christmas, anyway.

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Thank you for the meal we eat,

So long as it’s not tainted meat.

And bless our little girls and boys,

Just keep them safe from lead paint toys.

In food and kid consumer sectors,

We need a few more good inspectors.

And bless our humble family dwelling;

May we be spared foreclosure selling.

Go gentle on the Federal Reserve;

They get more blame than they deserve.

The subprime game’s become a bore,

But it helps us to forget the War

And remember that it’s always wrong,

To borrow short and lend it long.

Bless CDOs and SIVs,

But not the rating agencies.

And grant O Lord your intercession

To save us from the next recession.

For nothing could be truly lamer,

Than depending on the word from Cramer.

It’s true our world is getting smaller,

And so is the almighty dollar.

Please save us from the folks who wondered

How soon that oil would reach one hundred.

Lord bless our land, our sovereign nation,

So we can deal with immigration.

And grant us all the perseverance

For universal health insurance.

The year ahead looks pretty grim;

I think it’s time to hit the gym!

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Ever since the subprime crisis burst on the financial scene in August shortly after the Dow broke 14,000, the equity markets have been like a stool propped up on four legs:

1) technology: thought to have at least six degrees of separation from the subprime/credit crunch/bank write-off mess;

2) China; thought to have similar separation except for a few of its area banks and considered to be a market of unending appetite for…

3) oil and commodities: the rapid rise of oil from the mid-70′s to the mid 90′s, and the accompanying rise in commodity prices, all fueled to some extent by the fall of the dollar in turn fueled by…

4) two Federal Reserve interest rate cuts aggregating 75 basis points, triggering a steady and accelerating fall in the US dollar’s value on world currency markets and to some degree helping US exporter profits  and our balance of trade figures while also fostering fears of inflationary tendencies owing to higher import prices for goods beyond oil and commodities.

Until very recently, stocks with some connection to items 1, 2 and 3 and otherwise sound business results were doing very well and holding up the market averages within a few percentage points of the all-time high (in the case of the Dow) and the best performance since the dot-com crash (in the case of NASDAQ).

Suddenly, however, it all began to unravel as investors began to notice the internal inconsistencies in the four legs of the stool –  to some degree, these market props were sowing the seed of their own destruction in terms specifically of their tendency to promote inflationary expectations which in turn would curtail further interest rate cuts, thus knocking out at least one of the props. Indeed, Fed Chariman Bernanke virtually said as much in his testimony to the Congres this week.

Well, a stool can get by on three legs, of course, if they are well-positioned, but the others got as wobbly as the San Andres fault this week with a little jolt from Silicon Valley itself, in the form of commentary from Honest John Chambers, CEO of Cisco, who indicated that technology sales might not be so immune from the effects of the suprime crisis after all in terms of slowing domestic orders from financial institutions (worried about their balance sheets), automakers (worried about slipping sales to credit-challenged consumers) and retailers (ditto).

In turn, fears of a busines investment slowdown in the hard-driving tech sector not only hit the market face like a wet dishrag, they also called into question the “global growth” story at the heart of the China and Commodities props. Indeed, oil — speculated early last week to be irretrievably heading to a price of $100 per barrel, was in retreat by Sunday night and into Monday as fear of recession (see my blog of a couple months ago predicting the rise of the R-word) took hold. Even China is immune from the potential effects of a US slowdown, it seems.

The straw that breaks the markets back, however, may not just be the removal of the four props, but the good old fashioned margin calls that apparently came thick and fast with Monday’s sunrise. It will be interesting to see what transpires Tuesday when the banks go back to work and their money managers survey the carnage. Black Tuesday, anyone?  In any event, it looks like this roller coaster may head down again before heading up when it finds some new props. This will be a wild and woolly week.

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

When the patient wakes up from cancer surgery, the first logical question is “Did you get it all?” If the answer is unfortunately “No”,  you probably have another operation. But if the answer then is “No” a second time, you most likely get another surgeon!

 Balance sheet problems at banks, like the one caused now by the subrpime mortage/credit meltdown and related difficulty in marking-to-market the related assets held by major financial institutions, are like a kind of cancer, and since we are now coming into the third rounds of surgery in the form of announced billion-dollar write-downs, it’s little wonder that shareholders are demanding that boards of directors find another surgeon — starting with Merrill Lynch and now Citigroup.

Neither if these CEO’s apparently “got it all’ the first time around, or even the second. The markets punished their respective stocks severely, the boards held emergency meetings, and both gentlemen have “resigned”.

Interestingly, neither board was ready to install a new surgical team, instead opting for an interim period of something like “palliative care” of their wounded staffs (if not their balance sheets). No doubt executive search firms are working overtime coming up with lists of usual suspects for these positions with the right surgical resume, plus much-needed ability to guide the patient through post-operative recuperation. This period will probably involve less strenuous exercise of the M&A muscle both may have overworked recently, overconfident of the worth of the supposedly “AAA” assets on their balance sheets which are now in tatters thanks to rating agencies that simply blew the coverage worse than an NFL cornerback trying to keep pace with Randy Moss with the game on the line!

There will be more time for detailed diagnosis later on after the new surgical teams take charge; the question for the moment is really “Who’s next?” And the other question lurking is how on earth do financial institutions ride heard on their risk profiles when the only people truly competent to understand the risk imbedded in the instruments they hold are their own creators, who design them specifically to be opaque to independent, outside consultants (let alone unwary purchasers)?

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