James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — With QE2 set to end in five weeks and with Greece rolling downhill towards default, the world is not best placed to withstand a weakening economy.

That, however, is exactly what looks to be happening, as Asian demand is hit by a cooling China and a struggling Japan.

Let’s take a look at the evidence:

Japan’s economy shrank by 0.9 percent in the three months to March, battered by the earthquake, tsunami and ongoing nuclear fiasco.

The preliminary HSBC/Markit purchasing managers’ index for China fell to 51.1 in May from a final reading of 51.8 in April, holding in expansionary territory above 50 but amidst growing evidence that China is coming off the boil. Chinese demand for raw materials and semi-finished products has been one of the global economy’s principal supports, but now a monetary policy tightening campaign may be gaining traction.

The Chicago Fed national index, derived itself from 85 economic indicators, came in at negative 0.45 in April compared to 0.32 in March. There are numerous signals of an industrial slowdown in the U.S., while the housing market continues to weaken, threatening financial stability and consumer spending.

Finally, in Europe the euro zone composite flash PMI, an indicator combining service sector and manufacturing purchasing, fell to 55.4 from 57.8. More worryingly, the headline manufacturing index had its biggest fall since Lehman Brothers failed, falling by 3.1 points to 54.8.

“All in all it seems to us that the odds are high that a domestic and global economic slowdown is already in place.  In the U.S. the slowdown is happening with only weeks to go before the end of QE2, a program that has been a major prop for even the tepid recovery we’ve undergone so far,” said Charlie Minter of fund managers Comstock Partners in a note to clients.

“For the stock market nothing seems to matter until, suddenly, it does.”

It has begun to matter recently to the stock market, which has fallen in recent sessions after a sustained rally. The bond market has already figured this out; since mid-April U.S. 10-year yields are down more than 12 percent to 3.12 percent. Given that the U.S. debt market faces a debt showdown and the end of QE2, both factors which should theoretically send yields higher, this slide in yields shows real doubts about future growth.

CRUEL SUMMER

It is worth noting that the euro zone’s woes were not this time concentrated in the weak peripheral states; this time Germany got whacked too. That may well reflect the wrench thrown into production from Japanese plant closings, which in itself will self-correct. It is also likely reflecting a slowdown in demand for German products from China. If you believe that Chinese demand was artificially boosted by very easy credit, and that Chinese demand in turn was driving global growth, then this is an indicator of a very busy and volatile summer in financial markets.

Global markets have ignored, more or less, the euro zone’s issues for more than a year, but did so in a very supportive atmosphere. The Federal Reserve was buying up Treasuries, sending cash into risk markets in waves, while China continued to grow at a blistering pace. It may be that China is important not just because its slowdown affects demand, but because it lets investors focus on the actual prospects in the euro zone.

Will Germany and France be as willing to foot the bill for Greece if their own manufacturing bases begin to shrink? It is possible but a lot less likely.

Meanwhile the crisis both builds and spreads, with a dispute over debt reprofiling (a sort of doe-eyed default) between the European Central Bank and European officials and a fantasy plan by Greece to raise 15 billion euros through asset sales.

Greece may turn out to be a minor worry; Belgium and Italy have been threatened with credit downgrades by Fitch.

So what happens from here? A palatable outcome would be a gentle decline in economic momentum followed by a strong second half. This makes absorbing the impact from Europe easier, and makes it easier for Europe to come to terms with itself.

A less likely, perhaps, but still possible scenario is that the manufacturing slowdown gains speeds just as Europe faces a contagion from the periphery, either to parts of the core, to the banking system of the core, or both.

At this point the Federal Reserve will have an ugly choice; does it extend and expand quantitative easing to support the newly weakening economy, or does it sit tight, brace for the recession and hope something else will turn up?

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

A very poor outlook for housing will hold the U.S. economy back in coming months, making it very unlikely that the Federal Reserve will be able to step back from their emergency room monetary measures.

A genuinely encouraging run of data and very strong asset markets has encouraged some to argue that the Fed’s policy will prove to have been too much for too long, but housing stands out as the one asset market that has failed to respond encouragingly to the adrenaline of quantitative easing.

The Fed acknowledged this in the minutes of their December monetary policy meeting, listing a litany of factors holding housing back and stating:

“The recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and lower prices in the housing sector and potential financial and economic spillovers if the banking and sovereign debt problems in Europe were to worsen.”

While it is hard to see how the European difficulties will be resolved happily, it is virtually impossible to work out a road map for 2011 in which housing is anything other than a drag and a risk.

Put as simply as possible there is simply too much debt secured against U.S. residential real estate and the debt is being serviced by people with too little income to subsidize an asset worth less than the debt by choice.

S&P/Case-Shiller said at the end of December that its index of house prices fell for the third month running and is now in negative territory on a year’s view for the first time in nine months.

Those figures too predate a sizable rise in mortgage interest rates in the past several weeks. According to a survey by Bankrate.com, average rates for a 30-year fixed mortgage topped 5.0 percent at the end of 2010, up from about 4.25 in the spring and 4.40 percent as recently as November.

While the backup in mortgage rates is partly a function of economic optimism, it is also the fruit of a Fed policy designed to goose financial asset markets.

That’s made stocks more attractive and encouraged funds to flow out of bonds.

It is important to understand that housing was as weak as it was last year even with 40-year lows in mortgage rates because employment was weak, supply high, and a foreclosure pipeline that remains very strong.  These are all factors that have proved to be fairly unresponsive to policy, either monetary policy or programs to provide mortgage relief.

WILL DEFAULTS EASE?

Foreclosed properties are not just bad for housing because they represent supply, but because banks sell them quickly, often at prices well below recent comparable sales. That sets a precedent for the market, making sales at higher prices more difficult. It is also terribly depressing for homeowners carrying more debt on their houses than they are currently worth.

It is this group, many of whom are employed and able to make payments, who really represent a threat to prices in the coming year.

“Borrowers with good pay histories who aresubstantially underwater have shown that they, too, have a reasonable probability of transitioning to default,” mortgage analysts at Amherst Securities, led by Laurie Goodman, wrote in a recent report.

“Yet many bond investors, and a number of housing analysts, are focusing solely on non-performing loans; they ignore re-performing loans and seriously underwater borrowers. The market is underestimating the housing problem and potential losses to bondholders if further policy actions are not taken,” they said.

Amherst analyzed the non-conforming mortgage market, large or risky loans not made by Fannie Mae or Freddie Mac, and concluded that there is a large group of loans that now look good that may well turn sour.

One particular group is loans that had been non-performing but that have “cured,” returned to making payments. This accounts for about 15 percent of the non-conforming market, but the odds for these people are not good. After two years more than half will have re-defaulted, according to the study.

A potentially larger group is those who’ve always paid on time but who are servicing a mortgage that is bigger than their house is.

Looking at clean borrowers from a year ago whose mortgage was worth 120 percent of their house value, only about 77 percent remained current or paid the loan back in full.

Given declining home prices that argues for a continued gusher of foreclosures, foreclosures that will further weaken house prices and encourage yet more defaults.

Many of those defaults won’t be borne by the banking system, the risk having been transferred to the government, but they will suppress consumer sentiment and spending and probably mean that quantitative easing and very low rates will be with us for quite a while.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

We’ve entered a new era in global financial markets: the U.S. is intentionally devaluing the dollar.

For the U.S., which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out.
The Federal Reserve on Wednesday moved to open a second round of quantitative easing, pledging to purchase a total of $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year. As well, the Fed will reinvest $250-300 billion in the same period, meaning that the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether.

Perhaps the principal way QE will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms.

The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by QE will be made not in the U.S. but will be money borrowed in the U.S., exchanged into a foreign currency, probably an emerging markets one, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive.

There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull.

Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless.

“Devaluation is the intention, and devaluation is what is going to happen,” Avinash Persaud, Chairman of Elara Capital told the Forex Forum conference in New York on Tuesday.

We can surely expect the U.S. to deny this, as Treasury Secretary Timothy Geithner did in October, but the truth will be seen in the foreign exchange markets, where the dollar has been falling and will fall further as the year winds down.

GETTING THE GENIE BACK INTO THE BOTTLE

It is most certainly in the power of the U.S. to begin a period of competitive devaluation. The U.S. dollar is a global reserve currency and the marginal cost to Bernanke of printing more is very low indeed. Less certain are the reactions of the rest of the world.

While the U.S. will surely have prepared the way for QE2 with its major trading partners (and in fact may be deliberately ticking off the Chinese) there remains a strong chance that a falling dollar sets off a range of tit-for-tat reactions. Already Korea and Brazil are moving to stem the appreciation of their own currency. Look too for the possibility of other countries joining in to QE, in part so that the Japanese yen, to name just one, does not rise too much against the dollar.

A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised.

The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden.

On the Fed’s reckoning it will go like this; QE2 and very low rates go on for an extended period, but almost as a matter of mechanics, when the Fed begins to tighten, the dollar recovers. The Fed has used the dollar lever to ease and then uses it to help to tighten. The dollar remains the principal global reserve currency and investors respond to the Fed’s incentives.

The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. When the time comes that the Fed, perhaps hurrying to prove its control, decides to stop QE2, bond investors want compensation for holding U.S. debt — a lot of compensation. U.S. equities, which have been held aloft by QE, duly fall sharply, as does the dollar, while yields spike. This is not a central case, but it is a possibility, and as it would be a disaster, one that needs to be watched closely.

Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.