Diversionary tactics or simple coincidence?

Pictures of a Stock Market Mania
Bankers caught between hope and despair
Russia 'ready for new Cold War' over Georgia
Problem bank list keeps growing
FDIC may have to borrow money to cover bank failures

Aug 26, 2008

Dollar bill

Something of note always happens, either in the financial markets or on the geopolitical stage, or both, when this particular writer leaves for vacation - on this occasion the lower slopes of another major force, Mount Etna on Sicily. In fact, the past couple of weeks have been packed with incident and yet equity markets have proved relatively sanguine. Perhaps everybody is away on holiday, perhaps equity markets are genuinely much more immune to the periodic eruptions of bad news, having become quite used to them over the past twelve months or so. Whatever the reason, equity markets have appeared sanguine in the face of a paroxysm in the currency markets, further gyrations in global commodity prices, the Beijing Olympics and war in South Ossetia (coupled, more recently, with the signing of a military agreement between Poland and the USA). The obvious question is; are all these events linked in some way? If, as we attempt to reveal below, the answer is yes then it would seem prudent to encourage investors to remain wary until this particular tremor subsides.

Over the past week or so attention has focused on the dollar’s surprise recovery on the foreign exchanges. Ostensibly this has everything to do with interest rate differentials and the outlook for base rates on either side of the Atlantic Ocean (we are far from blind to the impact that the dollar’s revival, coupled with weaker base metal and oil prices, is having on the economies and investors elsewhere in the world but this note is back on familiar ground for conspiracy theorists). We have some sympathy with the view that UK and EU base rates will fall once headline inflationary pressure abates. Our expectation is that, in the not-too-distant future, headline inflation will peak and then begin to fall back.

Understandably, central bankers are becoming increasingly exercised by the outlook for growth. In the United States investors seem to be opting for the view that (despite its many pitfalls) headline Real Gross Domestic Product (GDP) will remain in positive territory. An upward revision to initial Q2 2008 output data has reinforced the perception that the next move in US base rates will be up rather than down. We do not agree. Earlier Week in Preview articles have illustrated the risks associated with pinning one’s colours too hard to that particular mast. Even if one were to adopt this folly, our assessment remains that the US economy could easily “double dip” as 2008 progresses into 2009. The positive impact of earlier tax rebates is probably past its zenith, while the positive impact of net exports may be undermined were the dollar’s revival to become entrenched. All that without the grinding inexorability of the credit crunch and its depressing impact on the housing market, consumer confidence and consumption. On balance we still think that the Federal Reserve has the scope to cut rates as activity slows.


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