Reflation Again!

Interesting move in the markets this afternoon with Dow up 300+ points on the rate cut news. I think its interesting to discuss the implications of this move regarding two important economic trends:

1) Asset Price Risks - Here I am talking about debt obligations, stocks, and real estate. US as a Country and on individual person basis is highly leveraged and exposed to the ongoing problems in the real estate market. Credit terms have tightened significantly over the past three months so that banks are less eager to lend on real estate and interest rates have also risen for most types of mortgage debt. Debt obligations are in danger because consumers are unable to switch to new cheaper financing options once their current short term low rate period ends on their credit card or mortgage. This reintroduces credit risk in the equation and forces real returns higher. Equities are more of an afterthought as they may be liquidated to raise cash and meet margin calls.

All of the above issues are classic debt deflation theory which has been around since the Great Depression. The basic concept is just that in a society as debt craving as we are - when the terms of the borrowing become more expensive and payments can no longer be made, the consumer defaults, the asset is repossessed and then resold for a lower price. This kills the economy and pushes us into deflationary reccession / depression situation. This is the scenario I believe the Fed most fears and they are attempting to combat it head on with the 50 basis point cut. The move is largely symbolic, but to the extent that it can function to drive money market rates and short term rates lower it may help to reintroduce some sanity in the yield curve and appetite for longer term obligations.

2) Commodity Price Risks -

The Fed's challenge is they are walking the trapeze. They are trying to have their cake and eat it too. Today's statement basically said - hey - we are going to control inflation and promote growth. With gold hitting new highs though in the 720s today, oil at $80+ per barrel, and the dollar going to new lows against foreign currencies - you have to bet that the Fed is sacrificing inflation concerns to confront the bigger issue of the pending asset deflation discussed above.

Ironically - I tend to side with the Fed - I believe the bigger issue is the massive defaults forthcoming in real estate market and debt obligations and more acommodative monetary policy may make these more manageable. The important point still is perception, however, and on the surface at least it looks like the Fed has made a decision to reflate or perhaps better phrased - "prop up" asset prices at a questionable time.

I would take advantage of this rally to short US financials at better entry points, I would also be selling some US stocks exposed in riskier areas such as retail, real estate, and banking and be raising cash funds to buy into gold and emerging markets on next dip.

-Ben