Friday Morning Thoughts

Yesterday, market sentiment shifted to really worrying about a severe global recession and the deflation that would come with it. Since sentiment is 9/10ths of the market, that means a lot.

And don't pin your hopes on the bailout package stopping the credit crunch and saving the economy. As Paul Krugman noted: "To this day [the bailout proponents] have never been able to explain clearly why buying up bad mortgage assets at market prices will solve the credit crunch...The Wise Men, as far as I can tell, have never had a clear idea of what they're doing."

I had been somewhat ambivalent toward the proposed $850 billion (porked up from $700 billion) bailout package, because I thought, well, maybe it might work. But those hopes seem to be fading.

What would I propose? I think the government should take equity stakes in banks it thinks can survive -- recapitalizing them in exchange for partial ownership -- and dispose of the assets of failing banks through a Resolution Trust Corp-type vehicle (a la the S&L Crisis). Meanwhile, raise the FDIC insurance to $250,000 per account -- just to keep up with inflation, it should be $220,000 anyway -- and inject a bunch of cash into the FDIC to reassure consumers. Later, when the banks get back on their feet, the government can sell its equity stakes back into the market.

When the House of Representatives rejected the revised Paulson plan, that was a chance for leaders in Congress to come up with a new plan, one that really addressed the problem. Instead, they just larded the revised Paulson plan up with pork to swing a few votes. That's a real failure of leadership.

What's more, if this bailout package doesn't do the trick -- and I'm starting to think it won't -- that means we'll need ANOTHER bailout package after that.

Meanwhile, fears of a severe recession and accompanying deflation will only get worse. As my colleague Mike Larson pointed out in an email yesterday:

The federal funds rate target, as you all know, is 2%. There is a lot of talk about how the Fed may (MAY) do an emergency rate cut soon. Fed funds futures market is actually pricing in a 90%+ chance of a 50-point cut by the end of October (Fed next meets on 10/29). But look at this chart below. The ACTUAL fed funds rate is much lower than 2% and has been for most of the past several days. Last I checked, it was 0.625%, down 19 bps on the day. It’s so low, in fact, that it has taken out its absolute low from the 2003 deflation scare period, when the official target was 1%. Five-year inflation breakeven rates (5-year nominal treasury yield – 5-year TIPS yield) have plunged to 103 bps from around 270 bps this summer. The absolute low was 82 bps way back in 2001 at the bottom of the last bear market.

In other words, the credit markets are rapidly shifting to deflation fears and the Fed is doing everything it can to fight that … but losing.

I believe that deflation will be unacceptable to whatever administration takes power next year. If a government has to choose between the two, inflation is the much better option, because it becomes cheaper to pay off your debts in the future (what's $850 billion between friends when the value of the dollar is going down?). So, I'd expect spending on public works to soar, and the government to borrow a lot of money to do it. And that should be a good environment for gold.

And then there's this ...

Asia Needs Deal to Prevent Panic Selling of U.S. Debt, Yu Says

Japan, China and other holders of U.S. government debt must quickly reach an agreement to prevent panic sales leading to a global financial collapse, said Yu Yongding, a former adviser to the Chinese central bank.
An agreement is needed so that no nation rushes to sell, "causing a collapse,'' Yu said. Japan is the biggest owner of U.S. Treasury bills, holding $593 billion, and China is second with $519 billion. Asian countries together hold half of the $2.67 trillion total held by foreign nations.

I don't think the chances for financial panic have gone down ... if anything, they're increasing. A panic is when you want to be holding gold ... and probably silver, too.

In the short term, the US dollar should continue to rally as the euro collapses in on itself. This could weigh on gold ... or it could not. You'll remember that gold and the dollar disconnected for all of 2005. In these calamitous times, we could see global investors rush into both gold and the dollar as they seek safety.

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