Wednesday, September 19, 2007

Newtonian Economics 101

Yesterday afternoon, I swear I heard Martha and The Vandella’s singing “Dancing in the Streets” as the Fed dropped interest rates a half-percent, bowing to the howls of the Wall Street crowd. The S&P 500 closed with a nearly 3% gain, and the Dow rocketed over 300-points, landing somewhere north of 13,700. Hope you’re happy.

Six and a half years ago, the Fed began to cut rates, dropping from 6.5% to 1% by the middle of 2003. The S&P 500 lost half of its value as a result. I’m not going to be a nattering naybob of negativity here, but just telling it like it is.

Anytime you have a 332-point rally in the Dow in one day, there is going to be a corresponding dive. Has to happen. Newtonian economics dictate what goes up, must come down, and there is a proportionality involved in the rate of climb and descent. So, be careful what you ask for.

Several really smart people with whom we talk regularly believe yesterday’s adjustment is a short term victory at best. The lower rates may assuage the effects of any recessionary inclinations, but hand in hand with the dropping of rates is the loss of value in the Dollar.

This is disconcerting because as the value of the Dollar declines, the cost of things important to you and me, like, say, oil for example, is going to go up. While commodities traders and Exxon stock holders love it when oil runs at $80+ a barrel, such pricing is fueling the flames of inflation (apologies for the pun-ish metaphor)…and wasn’t that what the Fed was allegedly trying to avoid with its Monetary Policy?

Interestingly, when oil was in the $70’s, and gasoline was $3/gal, the US economy still managed to hum right along. Perhaps that elusive pain threshold may be crossed at $85-bbl and $3.50/gal. Then again, maybe not. Even OPEC last week admitted $80 oil is an unsustainable price point.

Another fear being expressed is that as the Dollar’s value diminishes, holders of US debt may be tempted to cash-out. True enough, but to which other currency might they flee? Trading Dollars for Euros or Dollars for Yen or Rupees is not too sexy.

Might a weaker Dollar make it more difficult for the Government to fund its debts (which are really our debt), thus causing bonds yields to go up? What do you think will happen if yesterday’s cuts don’t work, and Ben and the Boys and Girls have to adjust rates downward? ‘Tis a slippery slope…

Maybe it was the bond traders that were dancing with Martha yesterday.

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