Will she or won’t she? That’s the question. The answer will be forthcoming. Meantime, there’s the debate, speculation and outright guessing about whether Hurricane Katrina is the straw that pushes the economy into recession.

As usual, the bond market is the front line in such debates. The benchmark 10-year Treasury Note’s yield has fallen in recent days, suggesting that the risk of an economic slowdown has risen in Katrina’s wake of devastation. The 10-year’s yield ended today’s session roughly unchanged from Thursday, at just over 4.0%. That’s down 20 basis points from a week ago, and about 40 basis points below the yield’s high for August.
The immediate catalyst: Katrina has exacerbated an already tight energy market, particularly in gasoline, pushing prices up and raising the specter that consumer spending will fall of a cliff. Then again, even before the hurricane, gasoline stocks in the U.S. had been falling sharply, according to the Energy Information Administration. Gasoline stocks for the week ending August 26 were the lowest since November 2003.
A lack of oil isn’t really the problem at the moment; rather, the dearth of spare refinery capacity is the culprit, a problem that’s been years in the making, courtesy of no new refinery development since the dark ages. Regardless, when Katrina struck, shutting operations at nine refineries, or about 10% of the nation’s capacity, the supply squeeze for gasoline moved from worrisome to dire. The U.S. has long relied on the Gulf Coast for too much refinery capacity, and that bet suddenly has come back to bite the economy.
Yes, gasoline futures pulled back again today, reversing most of the two-day surge from Tuesday and Wednesday. But the refinery shutdowns aren’t likely to be reversed quickly, and the question is whether the energy shock in its latest incarnation will push the economy over the edge.
On that note, some pundits are saying that the Federal Reserve will suspend the interest rate hikes that have prevailed at every Federal Open Market Committee meeting since June 2004. While such talk has kept the bond bulls happy, it’s sparked renewed fears for the greenback. Indeed, one of the dollar’s props of late has been the Fed’s ongoing interest rate hikes. If that prop is gone, what are the buck’s prospects?
Something less than bullish, or so traders think at the moment. The U.S. Dollar Index suffered its biggest declines in recent memory of late. For the week, the Dollar Index dropped 1.3%, falling to its lowest since May.
Are speculators getting ahead of themselves? After all, this morning’s jobs report for August still paints a relatively rosy picture of an economy continuing to hum along. Nonfarm payrolls continued to move higher last month, with 169,000 new jobs added. That helped reduce the nation’s unemployment rate to 4.9%, the lowest in four years.
But the data was compiled before Katrina’s devastation has worked its way into the economic facts. As such, pre-Katrina economics reports are fated to be dead on arrival. The retail sales report for August, due for release on September 14, for instance, promises to be of little, if any consequence in weighing the future.
Instead, the post-Katrina effects are what interests the dismal scientists, and getting a handle on that will take time, perhaps months. Meanwhile, there’s no shortage of predictions. “Our bet,” writes TrendMacrolytics chief economist David Gitlitz today in a letter to clients, “is that these expectations [of lower interest rates of the moment] are highly unlikely to be sustained, and that the Fed’s default position remains to move to restore equilibrium at a rate of 25 bps per meeting, putting the year-end target at 4.25%.”
If so, that would imply the economy takes a minor hit, and a temporary one at that. But you don’t have to look far to find a darker view of what awaits. “Katrina is very big and, in economic terms, very deep,” warns David Kotok, chief investment officer of Cumberland Advisors, in a note to clients yesterday. “Katrina has the potential to be bigger in financial market terms than the 2004 hurricane season or any other modern American catastrophe other than war.” Until there’s more clarity, Kotok’s counseling investors to be “very careful. It is too soon to act speculatively. The damage assessment is underway and very much incomplete. Trying to buy something new here may be like catching a falling knife. You can do it successfully but it is a high risk venture.” As such, Kotok’s pursuing a “defensive, shorter-duration strategy on bonds” and “maintaining the cash reserve in its ETF accounts.”
The recent economic climate was complex enough. Now there’s the Katrina factor to add to the analysis. For some, however, it only brings clarity. As Peter Schiff of Euro Pacific Capital observes in a note dated yesterday, “The U.S. economy, which has clearly been a bubble in search of a pin, may have finally found one in Hurricane Katrina.”
Yet with so much pessimism, why is the stock market holding up so well? The S&P 500 actually rose slightly for the week. Do equity traders see a different future than the bond market? Of course. Some things never change.

4 thoughts on “THE LADY IS A TRAMP

  1. Mans

    The real bubble in the US is the bond market. Until it pops the secondary bubbles in stocks, real estate and mortgages will stay elevated.
    So watch the bond market. As long as it is the beneficiary of the rush to “quality” trade everything else will stay elevated.

  2. Jonathan

    Dear bond bear, the flipside of the credit cycle won’t be bearish for bonds.
    Market players have got JGBs wrong for over a decade, and seem to be keen on repeating history by repeatedly calling for a bond bear market in the west as we crest close to the peak of our own credit bubble.

  3. Mans

    Japan has a current account surplus. A small unobtrusive deflation also works in their favor.
    Equating the US with Japan is not thoughtful analysis.

  4. Jonathan

    Bond Bear, ‘Equating the US with Japan is not thoughtful analysis’? Neither is this statement?!
    I did not. However there are particularly strong parallels. What we have seen over the last 15 or so years in Japan is the unwinding of malinvestment encouraged by excess credit. The U.S. etc have enjoyed a huge credit expansion over the last few years. We may disagree how it will play out but initially it is likely (IMHO) to be negative for inflation, rates etc.
    Picking one macro variable to ‘explain’ Japanese bond yields is very unhelpful not to mention crass as everyone is full of explanations for Japan in hindsight. I was a bond trader in Tokyo for some years and no one had smart answers for falling bond yields when it was happening, only in hindsight. I fear the same will be the case for USTs and European bond yields… maybe calling it a bubble or a conundrum will explain away why most people have been riding the wrong side of it. Not for those who rely on actual market prices, not where they ‘ought’ to be. You can’t feed your kids with money you ‘ought’ to have made from where the markets ‘ought’ to be.

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