US Economy Sliding towards "Stagflation"
Global Bond Vigilantes Hooked on Gold

Gary Dorsch
Editor Global Money Trends magazine
Oct 4, 2007

Nowadays, traders of all different stripes are betting on more rate cuts by the Federal Reserve in the months ahead. Since mid-July, the odds of a US economic recession have been mounting, led by sliding home prices and the first loss of US jobs in four years in August. Sales of new single-family homes fell 8.3% in August to a 795,000 annual sales pace, to stand 21.3% lower from a year ago, and the glut of unsold existing US homes has swelled to the highest in 18-years.

Robert Shiller, a Yale university economist, told a US Congressional panel on Sept 19th, "The collapse of US home prices might turn out to be the most severe since the Great Depression. The decline in house prices stand to create future dislocations, like the credit crisis we have just seen." According to the S&P/Case Shiller national home price index, US home prices in the top-20 metropolitan areas fell 0.4% in July from June, to stand 3.9% lower from a year earlier.

Former Fed chief "Easy" Al Greenspan said on Sept 16th, the he would not be surprised if US home prices fell by double-digits into 2008. A fall in home prices on that scale would be unprecedented in US history. US residential real estate has an aggregate value of about $21 trillion, and is the single biggest source of US household wealth. If home prices fall roughly 15%, it could wipe out $3 trillion of household wealth, and deal a huge blow to consumer spending.

A double-digit decline in US home prices could also spark big job losses. Construction employment fell about 15% in both the 1990's and 1980's recessions, and it dropped 18% in the recession of the mid-1970's. In each case, the sector's declines were far steeper than job losses in the overall economy, and the recovery took longer. About 7.6 million Americans workers are employed by construction companies, so a 15% decline would translate into the loss of 1 million jobs.

According to ADP Employer Services, employment in the construction sector fell by 20,000 in September, the 12th decline in thirteen months, bringing the total decline since August of 2006 to 157,000 workers. The US Labor department appears to be vastly overstating the level of employment in the construction sector, which is far out of alignment with the 44% plunge in US building permits from two years ago.

It's not just the prospect of a sharp decline in US homes prices which has the Bernanke Fed in a state of panic. About 5 million adjustable-rate mortgages are slated to reset to higher rates in the next 18-months. Therefore, the housing slump could deepen if the Fed doesn't lower short-term rates, to ease the plight of homeowners who are unable to refinance loans under tighter underwriting guidelines and as home values stagnate or fall.

US Treasury Traders bet on more Fed rate cuts

Historically, the US economy has gone into recession seven times since 1960, and six of the downturns were foreshadowed by an Inverted yield curve, when yields on three-month Treasury bills are higher than for ten-year Treasury Notes. Usually, when lenders in the bond market are willing to accept lower interest rates for longer term debt than for shorter term debt, it is a signal that the US economy is about to experience a serious slowdown or even a recession within 12-months.

So far in this decade, the Inverted yield curve has made two grand appearances. Between March and Dec 2000, at the height of the frenzy for internet and high tech stocks, the yield curve was inverted, but stock market bulls argued that its shape reflected the Clinton administration's retirement of longer term debt from huge budget surpluses. But the Nasdaq and S&P 500 did begin to implode in 2001, and an eight month economic recession arrived in 2002.

More recently, the yield curve inverted between February 2006 and June 2007. At its peak in February 2007, the yield on the US three-month T-bill rate was roughly 60 basis points above the benchmark 10-year yield. At that time, many analysts predicted the inversion would at least signal slower economic growth, but few were convinced it would spell a contraction of gross domestic product for two consecutive quarters, the typical definition of recession. The yield curve's only wrong signal was in 1966, when the curve inverted but no recession followed.

Nowadays, the US home prices are tumbling and threatening to drag the US economy into recession in 2008. According to former Fed chief "Easy" Al Greenspan, "The critical variable is the price of homes in the United States. I would expect home price declines to continue until the rate of inventory liquidation reaches its peak. And a weakened US consumer market, still has the capacity to impact our trading partners," Greenspan told a gathering of reporters in London on October 1st.

During the three previous Fed easing campaigns, whenever the two-year Treasury yield fell to more than -50 basis points below the fed funds target, the Fed lowered its target rate each period. In August 2007, the 2-year T-Note yield fell to -110 basis points below the 3-month T-bill rate, persuading the Fed to slash the fed funds rate by a larger-than-expected 50 bp on Sept 18th. The longer the spread between the two-year T-Note yield and the fed funds rate stays below -50 basis points, the greater the likelihood of more Fed rate cuts in the months ahead.

US Economy caught in "Stagflation" Trap?

Finally forced to choose between defending US home prices or the US dollar, the Bernanke Fed decided to sacrifice the greenback, and slashed the fed funds rate by 50 basis points to 4.75% on Sept 18th. "We took the action to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy. The resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans," Fed chief Ben Bernanke explained on Sept 20th.

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Oct 3, 2007
Gary Dorsch
SirChartsAlot
email: editor@sirchartsalot.com
website: www.sirchartsalot.com

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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group. As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADRs and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called,"Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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