Calling in the economic marines

At first glance there appears to be a large amount of confusion regarding the capital markets. After an awful August performance; September so far has been very positive.

Even though Buffalo Springfield is confused, I think I can shed some light on what’s happening here. In a nut shell, in 2007 and 2008 people and corporations stopped spending, inventories were pulled way down; when inventories started to build up in 2009 the economy got better. The National Bureau of Economic Research recently announced that the “Great Recession” began in December 2007 and ended in June 2009.

So, okay — things are good, no recession, people talk of a bottom in housing prices, unemployment although bad appears to have past its nadir. Then bam, the September 21, 2010 statement of the Fed Open Market Committee;

“Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent over the longer run, with its mandate to promote maximum employment and price stability. The Committee will continue to monitor the economic outlook and financial development and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation over time to levels consistent with its mandate.”

The confusion is how can companies meet their profit and earnings projections, sending stocks higher, if the Fed is willing to provide additional accommodation? If things are good, why should the Fed be looking to get involved? The rates are already at zero percent. In my opinion the Fed is signaling Quantitative Easing. This is rare; it is the economic equivalent of calling in the Marines.

Basically, the Fed creates dollars on its balance sheet. Then it utilizes those dollars to buy US Treasuries or for that matter mortgages, credit card debt, basically anything. The implications are huge. You don’t do this if everything is hunky dory.

If you create more dollars, then theoretically, all things being equal, the value of the dollar should decline. This has been the initial reaction; but all things are not equal. I believe for reasons mentioned in prior Cerebral Overrides, the situation in Europe is going to get ugly, and the dollar will eventually increase in value versus the Euro.

The value of gold should and has been going up. In my opinion, gold will begin to act more as a currency as the quantity of dollars increases and the European economy falls into an austerity induced deep recession. It is possible that central banks will begin to add gold as a reserve, replacing existing dollars and Euros.

My bullishness on bonds (rates to stay low) continues. If the Fed utilizes quantitative easing, in my opinion they will probably buy in 5-10 year Treasuries. This will of course increase the overall demand and should bring rates lower. The end game would be lower rates should increase demand for loans and get the economy moving again. I posit that is the point of the potential Fed action.

So…if the economy has to be jumpstarted, the engine must have a problem. No? Of course sometimes the check engine light goes on and nothing is wrong. Let’s just say it’s time to visit the mechanic for a check up, because there’s something happening here.

The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Smith Barney or its affiliates.
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