The Economy Guy

Issue: 12/10/07 Friday

Another irrational day on the stock market. The Dow went up 101 points, and is forging ahead to make new highs in the near term. The impetus is the Federal Reserve Meeting tomorrow, and the bet that they will reduce the Fed Funds by 0.25%. Countering this bet, the market is totally ignoring the “sub-prime mortgage meltdown” fallout that continues to happen.

Today the Bank of America closed the Columbia Strategic Cash Portfolio fund (what a great name – it makes you want to invest in it). The value of this fund has dropped from $34B to $12B in less than two weeks. Think about that for a second. How can anything’s value drop by 65% in less than two weeks? Leverage!!!!! That’s the only way. You might think they just invested in some junk, and you would be right. The sub-prime mortgage fallout just made $22B go to “money heaven.” (that’s $34B minus $12B = $22B). Okay, I promise I won’t do any more complicated math in this article.

WaMu (Washington Mutual for you old timers) just wrote off $1.6B and layed off 3000 employees because someone in the bank invested in sub-prime mortgage junk. That is $1.6B that just went to “money heaven.”

I’d like to take this opportunity to tell you about “money heaven.” I use that term to describe what happens when money is destroyed. Pretend that you have a pile of $100 bills – a big pile that can be used to create a big pyre. When those bills are turned to ash, the money just went to “money heaven.” Another term that I could use is deflation. Deflation is the opposite of inflation. Inflation happens when money is created, and put into the economy. Deflation is when money is destroyed, and removed from the economy – ergo “Money Heaven.” Also, I believe money can do great things in the world, especially philanthropic activities, so when money is destroyed, I am saddened – and wish that it goes to a better place.

How about the International market!!!

Swiss banking giant UBS AG said Monday it will write off a further $10 billion on losses in the U.S. sub-prime lending market and will raise capital by selling substantial stakes to Singapore and an unnamed investor in the Middle East. UBS said that the government of Singapore Investment Corp. is investing 11 billion francs ($9.75 billion), while an undisclosed strategic investor in the Middle East is contributing the other 2 billion francs ($1.77 billion). As recently as the middle of November, UBS had predicted a profit for the fourth quarter despite ongoing speculation about its sub-prime holdings.

My interpretation of this move by UBS is that they are coming to terms with their sub-prime loan losses, and allowing $10B to go to “money heaven.” This is another great example of how banks think. In November, this problem didn’t exist. In mid-December, it’s a $10B loss. Also note that UBS is raising more money than it wrote off. This implies that they are anticipating further losses!!!!!

You know that one of my base beliefs is that the sub-prime mortgage fallout is not over yet. More surprises are coming. The end of the year accounting should flush out some of those birds hiding in the bushes, but there will be some birds that just “lie” there – pun intended.

Here is how outsiders are weighing the chances of a Fed Funds rate reduction.

The highly anticipated FOMC rate decision will come this Tuesday at 14:15 EST. Currently, Fed fund futures are pricing in a 68 percent chance of a 25 basis point cut to 4.25 percent, but equity traders been increasingly betting that the central bank will cut them by 50bp in an attempt to prevent an all out recession. Nevertheless, of the 119 economists polled by Bloomberg News, 80 percent expect a 25bp cut, 16 percent expect no change, and a mere 4 percent anticipate a 50bp cut. How the Forex, fixed income, and equity markets will react on Tuesday afternoon will be dependent not only upon the actual policy decision but also on how badly the Federal Reserve judges the “strains on the financial markets” to be and whether they believe that “the upside risks to inflation roughly balance the downside risks to growth.”

If the U.S. does cut rates, it will follow in the footsteps of the Bank of England, which last week cut its benchmark rate to 5.5 percent from 5.75 percent and of Canada’s central bank, which cut its rate to 4.25 percent. The European Central Bank kept its rate unchanged at 4 percent last week but appeared to set the stage for a possible rate decrease sometime in early 2008.

The statistics show that the stock market is more ready to gamble that the Feds will cut the rate than the bond market. Also, play close attention to the quotes regarding the importance of the “strains on the financial markets” (this means too much money going to “money heaven” moving the economy toward recession), and “the upside risks to inflation roughly balance the downside risks to growth” (this means that the Fed better not forget about inflation – otherwise the markets won’t trust the Fed). Internationally, the Canadians and Brits have already positioned their interest rates so their exchange rates are not affected by our rate reduction. The EU is still thinking it over – very typical – behind the scenes there is a big argument between the French and the Germans.

Here are Monday’s closing details:
DJ30 – 13,727 (up 101 points)
10 year US Treasury Bond – 4.15% (up 0.03%)
Euro $1.4710
Gold closed at $814 per ounce. (up $13)
Oil Closed at $87.86 (down $0.42)
Gasoline is $2.25 (down $.02)