The recession will deepen even with aid for autos and additional stimulus

The recession is bound to deepen significantly, bringing with it outright deflation,lower market yields, soaring bankruptcies, plunging corporate profits and massive layoffs. That is a realistic appraisal of the economic and financial outlook even with the $1 trillion stimulus package recommended by the President-elect Obama team and the likely prospect of a Bush Administration commitment of Federal funds to stave off the threatened near-term bankruptcy of GM and Chrysler and eventually Ford as well. There are too many economic and financial problems still to be resolved. These include the continuing plunge in home prices, a massive wave of coming foreclosures as mortgages reset at higher interest rates, a continuing credit crunch for individuals, businesses, and state and local governments, and for some a further or drastic cut in credit availability.

Federal financial assistance to the big three auto manufacturers wiil only purchase time for the auto industry to at best begin to craft an effective response to the plunge in auto sales and allow for the shift in responsibility for further Federal assistance to the next Administration and Congress. Unfortunately, health care and pension obligations for retired US auto workers, so called legacy costs, outstrip comparable imbedded costs for competing foreign cars, even those produced in the US. The $70 per hour average labor cost of the big three US auto manufacturers vastly exceeds the roughly $45 per hour average labor costs for foreign name cars manufactured in the US. Those differences amount to some $2,000 higher costs for the US auto manufacturers than their foreign competitors. Also, there are too many big three models for efficient production and marketing. However, binding contracts with their dealer network make it virtually impossible for the US auto manufacturers to make necessary changes without the assistance of a bankruptcy court. Those problems would make effective competition very difficult even under normal circumstances. And these are not normal circumstances. With the threat of bankruptcy especially hanging over GM, there is already a noticable further deterioration in dealer showroom customer traffic. Foreign auto manufacturers also face difficulties, though not quite as pronounced. Nevertheless, in general, they are getting assistance from their governments.

Without US auto industry assistance, the recession will risk being turned into a depression. But, even with this aid, the recession is destined to dramatically worsen. This past week's rise in initial claims for unemployment benefits to 573,000 (for the week of December 6), a 26-year high, up from 515,000 the week before, suggests another outsized decline in the December employment, to be reported in the first week of January. December nonfarm payrolls are likely to drop sharply, probabaly as large or even larger than the precipitous 533,000 November decline. The December unemployment rate is likely to rise to 6.9% or 7.0% from 6.7%. But, the rise in the official unemployment rate will likely continue all through 2009 into 2010, possibly reaching 10% or more.

With such prospects and a likely outright decline in consumer and business prices it should come as no surprise that there has been a flight to the safey of US Treasury securities. The flight has been so pronounced that short-term three month Treasury bill yields not only fell to zero, they temporarily declined into negative yield territory as investors became more concerned with safety and liquidity than with the return on their investments. There were sharp declines in yields on longer term maturities as well. The yield on the Treasury ten-year note declined to a intraday low of 2.497% on Friday, but ended the week at 2.57% down from 2.91% two weeks earlier and 3.74% on November 14. The yield on the Treasury 30-year also fell in tandem to 3.06% in the latest week from 3.43% two weeks ago and 4.22% on November 14. It may be time to take some profits in Treasuries prior to the turn of the year on a precautionary basis. Some institutions may be building up a portfolio only for year end statement purposes, called window dressing, planning to sell Treasuries and move into riskier assets in the new year. That might temporarily boost equities at the expense of Treasuries. But, any significant backup in Treasury yields would would create a new buying opportunity, just as any significant rise in equities could constitute a shorting opportunity.

The 3.0% Treasury bond yield is only consistent with a projected zero inflation rate. A 1% projected decline in inflation would be consistent with a 2.0% Treasury 30-year yield. That forecast could even be conservative. In Japan, Japanese government bond yields fell below 1.0% amidst their deflation experience.

Next week the Fed is likely to cut its Federal Funds rate from its current 1.0% already historically low target, by anywhere from one-quarter to three quarters of a percentage point, with a resulting funds rate level of 0.25%, 0.50% or 0.75%. Unfortunately, it will not do the trick. Credit availability remains far too constrained.

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

Email address: philipbraverman@Gmail.com