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If Stocks are bid and Eurodollars offered, where’s the recession?

04 April 2008

The Macro Trader’s view:
Over the last couple of weeks interest rate futures in the US and UK have rejected their highs, and equity markets have rejected their lows. So the credit crisis is over. Or is it?

We don’t think so.

The turn of sentiment can be traced back over several key events that traders have mis-diagnosed as signs of an endgame in this credit crisis and therefore heralding a shallow recession.

1. The near collapse of Bear Sterns and its subsequent rescue by JPM Chase was clearly the catalyst,
2. The Fed’s last rate cut helped ignite a powerful rally in stocks globally, that was the undoing of the rally in interest rate futures markets in the US and UK,
3. The revised offer from JPM Chase seemed to add confirmation to what traders had started to believe; the worst could be over, and
4. The ability of both UBS and Lehman brothers to raise fresh capital in recent days after a huge write down by the former, and fears of collapse linked to the latter.

But we see these events as symptoms of deepening recession rather than signalling an end.

The US is in recession and going deeper because:

1. The housing market continues to correct with house prices falling at a pace not seen since 1968,
2. Unemployment has began to rise, as evidenced by the last two non-farm payroll reports, the latest offering in that series is due tomorrow and after today’s Jobless claims figure which came in at 407k, a level usually regarded as consistent with economic recession, prospects for tomorrows number cannot be good,
3. The two ISM surveys remain below the crucial 50 level, even though both of this week’s readings were slightly better than consensus.

But more importantly the availability of credit is still reducing for both consumers and Banks as the wholesale money markets remain dysfunctional with LIBOR rates way above levels that would be consistent with current official interest rates.

The UK is close to entering a recession because:

1. The housing market is well into the early stages of a severe correction, and at its current pace will soon be recording house price deflation,
2. Major lenders finding it increasingly difficult to access funds on the wholesale money market are increasing mortgage rates for both new and existing borrowers in an attempt to re-price risk and deter new lending,
3. Unlike the Fed, the Bank of England remains in a state of denial, continuing to sight inflation as the biggest threat, even though it is generated overseas by rising oil and commodity prices; domestic inflation, especially wage inflation is more benign, and
4. A clear sign of consumer distress is the rise in unsecured consumer credit released this week, with a commensurate drop reported in housing equity withdrawal.

Basically, as UK house price inflation recedes, home owners are unable to remortgage to maintain their spending, so they are turning to short-term debt. This will prove unsustainable and when that avenue closes, demand will fall and the economy will be in serious trouble.

So what does all this mean for equities and interest rates? In the Macro Trader’s opinion, these markets are confused. We see stocks resuming their sell-off once traders see beyond the events of recent weeks, and we see interest rate futures resuming their rally, as it becomes clear, the Fed and eventually, the Bank of England will cut rates further.

But for now we see no need to rush back into markets that are exhibiting such high levels of volatility.

The Technical Trader’s view:

The S&P has been trading sideways since the beginning of the year in the wide range of 1250-1400 and shows no signs yet of breaking out.

The market is in a state of great indecision.

The failure at the Old High of 1553 is a major failure.

And the creation of a Head and Shoulders Top is a true reversal.

But the bears have been impressed by the stubborn support from the Prior High at 1331.

And they will have noted that the power of the Double Headed Head and Shoulders Top will have been diminished since the achievement of the Top minimum target on the downside...

Stand back until there is a break of the range.

Meanwhile the short interest rate markets in the US have been rallying fiercely since mid-2007...

The detail of the market shows the acceleration since mid 2007.

Now look closer.

But close inspection of the day chart shows that they too are unchanged since the beginning of the year...


Note the small Head and Shoulders Top in place.

And the simultaneous break down through the long-term trend support from October last year...

These are good reasons to suggest that the market is very vulnerable to the downside.

If there is a clear breakdown of the H&S pattern the bears will be rejoicing.

The arguments of the Macro Trader notwithstanding, the charts suggest that the short-end may continue down for a while more. And the Stocks, with good resistance and support in place, may continue sideways for a while to come.

Mark Sturdy
John Lewis
Seven Days Ahead

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Ride the Eurodollars into the Recession

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