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Wednesday, October 15, 2008

The Multiple Edges of the Fear of a Recession

It was another wild day in the markets today. The Dow, S&P's, and the NASDAQ each gave back nearly ten percent today. The stated reason was a "fear of recession".

Now that the US consumer has finally hit the wall, there’s growing speculation the Federal Reserve will push its interest rate pedal to the floor.

September’s 1.2 percent decline in retail sales and downward revisions in the two previous months virtually assure the first quarterly decline in consumer spending in 17 years. That's something economists have been worrying about for some time, when it appeared the government’s fiscal stimulus package was having a limited

“I've said since the summer that a ‘dark period’ of economic data lie ahead,” Miller & Tabak’s chief bond market analyst Tony Crescenzi told clients in a note.

Some reading this that don't consider themselves "experts" in the equity markets might be asking themselves why the markets hadn't feared a recession prior to today. To the outsider observer, the market is suddenly fearing something that has long loomed over it. Unfortunately, often times the markets re discover things that have always been a potential problem and it causes significant short term volatility. Today's renewed worries over recessions are a case in point.

The news wasn't all bad though. This caused U.S. Treasuries to get significantly better today. If the market "fears a recession", (and by that I mean the fear it exhibited today) then that will make interest rates get better. I am now of the opinion that the only way for the housing market to stabilize is if we go through another mini refinancing boom. We approached that last week until the central banks cut short term rates in unison and pushed bonds up for the next four days. In my opinion, the only thing that will stabilize the housing market is interest rates so low that they cause good borrowers to act. Mortgage rates shot up nearly a full percentage point since last Wednesday however they improved by about a quarter of a percent today. As such, a "fear of a recession" might be the antidote necessary to eventually pull us out of a recession because if that fear is intense enough it will push mortgage rates to obscenely low levels. It was a similar fear in 2001-2003 that created the original refinancing boom. Most agree that in order to pull the economy out of this tail spin, one thing that is necessary is a stabilization of the housing market.

Of course, this fear is causing speculation on another matter. This is the matter of further rate cuts by the Federal Reserve. Now that we have "fears" of recession, we also have renewed speculation that the Fed will cut interest rates even further. The last Fed rate cut was viewed by the bond markets as inflationary and it was what caused Treasuries, and mortgage rates with them, to spike. If recession fears grip the market, then Bernanke will likely have no choice but to act. If he cuts SHORT TERM rates even more, the market for long term rates, headed by the ten year U.S. Treasury bond, will likely process this as another long term inflationary move. This will cause treasuries to spike again. The last rate cut caused Treasuries to gain six tenth of a percent and that translated into nearly a full percentage point higher in the thirty year fixed mortgage. A further rate cut might be seen even worse.

In other words, if the spector of a recession hangs over the market, then that might wind up being the best thing for the market. Yet, if it grips the market so much that it causes the Fed to act, then it might end up blowing up everything.

Everything continues to be very uncertain, and it's clear that each action creates a bigger reaction and ultimately it is very unclear what will shake out. For that reason, I continue to believe that the best investment right now is a volatility play.

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