The rally in equities and rise in Treasury yields are only temporary

Equity prices will drop sharply again after the current rally runs its course. Though the election results may well create some equity market euphoria, a renewed market decline could still come soon, perhaps by next Friday on, or even before in anticipation of, the next dramatic worsening of the employment picture. Given the high 475,000 four-week average increase in initial claims for unemployment benefits(479,000 in the latest week), it is reasonable to expect the October employment report next Friday to include a devastating up to 200,000 drop in nonfarm payrolls and a 0.2% further rise in the unemployment rate. Before this recession is over the unemployment rate is likely to top 8.0%.

But, regardless of the Friday employment report, a renewed plunge in equity prices is inevitable, certainty when the corporate profit outlook darkens dramatically, as it will, with the rapidly deteriorating economy. For expected changes in corporate profits are a key leading indicator and determinant of stock prices.

As stock market prices plunge anew there will be a return to the safe haven of Treasury securities. But the primary reason Treasury yields are destined to decline to and through their previous yield lows is the outlook for inflation. The global recession, with its plunging demand for commodities, finished goods and goods at all stages of production, capital investment, housing, real estate in general and labor, will produce not only a pronounced decline in the rate of inflation, but the prospect of outright deflation. Though the enormous size of the Federal rescue efforts will require a substantial increase in Treasury borrowing, the increase will be primarily in short-term maturities, where the demand is strongest and Fed actions most supportive. For the moment, however, the bond market's concern that the prospective increase in the supply of Treasury borrowing will exceed demand is overwhelming any optimism on inflation expectations. That view has even led some to short Treasury bonds. But, deflation potential and its eventual reality will ultimately win out.

If all of that is true, you might ask why the stock market rose sharply last week after one of the steepest declines since the depression over the preceeding three weeks, and why did Treasury yields rise over the past month? In that period, the yield on the ten-year, for example, rose more than a half percentage point to just under 4.0%.

The steep and seemingly consistent decline in prices on equities through the first three weeks of October encouraged such substantial short positioning that it created its own vulnerability. Recognizing that vulnerability, sentiment changed abruptly on Tuesday when it became clear that the Federal Reserve was about to cut the Federal funds rate to 1.0%, That growing positive sentiment was reinforced when the Fed did indeed cut the funds rate to 1.0% with a promise of further cuts as necessary,and especially when there was a round of parallel official interest rate reductions by other central banks across the globe with the expectation of more cuts to come. The combination of those coordinated rate cuts, signs of a slight easing in the commercial paper market and other frozen money markets, taken together, panicked investors who were heavily short into a pronounced short-covering rally. That in turn enticed other buying, especially after the 0.3% decline in third qurter real GDP was marginally better than had been feared. Though the rule of thumb that you can not fight the Fed is often correct. This time that buying rule is highly likely to prove wrong. The recession will be far more severe and protracted than the slight 0.3% third quarter real GDP decline might suggest.

The US economy is currently plunging. Real GDP is likely to decline by between 2% and 4% in the fourth quarter this year and through the first half next year and quite probably beyond. The consumer is being forced to drastically curtail spending. The decline in energy prices is lightening consumers financial burdens, but that improvement is more than offset by plunging consumer confidence, declining job prospects, and skidding income gains. Too much consumer debt and a tightening in credit standards put consumers in a financial bind. In addition, every other component of GDP except for Federal spending is cuurently in retreat. That points clearly to a consequent scale back in corporate earnings and a sharp reduction in consumer price increases, a prescrption for a renewed decline in equity prices and a resumption of the decline in Treasury yields.

One favorable development is the proposal to do something to ameliorate the soaring pace of foreclosures. The FDIC push to restructure Indymax mortgages facing foreclosure and the similar JP Morgan Chase voluntary initiatives to prevent foreclosures are promising developments that may help slow the decline in home prices. But much more needs to be done before there is any real basis for optimism that the credit crisis and far flung damage it has done and continues to do to the US and global economy is nearing an end. Even with all the government initiatives, the global recession is still destined to deepen precipitously.


Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

Email address: philipbraverman@gmail.com