The Continental Drift
that Could Bury the U.S.

By Andrew Gordon

Dear Reader,

Twenty-one of Europe’s most powerful bankers were sitting down to a sumptuous feast that evening in Frankfurt.  It was January 9th and it was blistering cold outside.  But inside the wine glasses were clinking and the conversation was convivial … even though the main topic couldn’t have been more serious.

You see, the European economy was showing signs of wear and tear.  That worried these diners, who came from Europe’s central and biggest private banks.  It wasn’t as bad as the U.S., but it was seemingly headed down the same road.

What to do?

They had the power to open up the money spigot, keep it as is, or tighten it.  They were all aware of the Fed’s increasing inclination to lower the U.S. benchmark rate to help fight off recession.

If it made sense in the U.S., why wouldn’t it also make sense in Europe?

As expected, the conversation was decidedly one-sided.  One by one, these bankers - every one of them at the pinnacle of their profession and confident in their knowledge and viewpoints - nodded in agreement.  It was unanimous.

There would be no rate cuts in Europe.  Inflation had to be defeated.  Nothing else mattered.

Now, let’s fast forward 12 days.  It was Martin Luther King Jr. Day in the U.S. and the markets were closed that Monday.  But they were open elsewhere.  And it was a terrible day for the global markets.  Shares plunged everywhere – in South America, Asia, and Europe.

We didn’t know why back then, but now we do.  It was because a guy somewhere in Paris lost a few billion dollars and the bank he worked for, Societe Generale, had begun quietly unwinding its losses.

But Fed chief Bernanke did not know that at the time.  He assumed it was a sign of plunging confidence in the U.S. and global economic growth.  He wanted to stop the bleeding before it got worse.  So he signed off on the biggest one-day rate reduction in recent history – 75 basis points.

Unfortunately, it wasn’t enough to keep the U.S. markets from falling further.  They’re now down 10 percent for the year.  Global markets have followed suit.

Yet Bernanke has been nothing but steadfast in ratcheting down rates and opening up the money supply.  When the Fed met one week later, he cut rates another half a percentage point.

All in all, since last September, rates have been cut by 2.25 percentage points.

Meanwhile, those 21 bankers who represent the European Central Bank (ECB) have been just as steadfast in not raising rates.  Last Thursday, it decided once again to leave rates unchanged.

Look, Europe is not the U.S. and the U.S. is not Europe.  Europe’s head banker, Jean-Claude Trichet, could be right and Bernanke could be wrong.  Or the other way around.  Or both could be right.  Both could also be wrong.

But, there’s no denying that Europe and the U.S. are going in opposite directions.  And that has consequences.

The first thing you need to know is that the Fed is constantly fighting two battles.  One involves doing the right thing.  The other involves managing expectations of what it does.  

If the Fed isn’t successful in managing expectations, it doesn’t matter if it does the right thing or not.  The market could come crashing down in a spasm of disappointment.

Or, another way of putting it is if it isn’t successful in managing expectations, then the right thing could become whatever it takes to meet expectations.

The ECB plays the same game.  In not raising rates, it also has to convince its unofficial constituency – the European markets – that it won’t raise rates in the future … unless the European economy deteriorates sharply.  

It’s been only partially successful at playing the expectations game so far.  A lot of market players and pundits believe it’s only a matter of time before Europe follows the U.S. in cranking down rates.

Here’s the conundrum.  The better the ECB is at playing this game, the bleaker the odds of the U.S. economy turning things around.

Let me explain to you what I mean.

The key is the U.S. dollar.  Lower and lower interest rates in the U.S. won’t be able to compete against the higher and steady European rate, especially if investors are convinced that rates will remain high.  Money will migrate to Europe and away from the U.S. in search of higher returns.  As a result, the dollar will weaken even more.  And that’s not good news for the U.S.

A flagging dollar will make U.S. imports more expensive, contributing to inflation.  More importantly, because it will take more devalued dollars to buy a given amount of, say, gold or silver, expensive commodities will get even pricier.  More than ever, investors will be encouraged to climb aboard the commodity gravy train as a hedge against a slumping dollar and rising inflation.

Where could relief come from?  Normally, global growth could help pull the U.S. out of a recession.  But in these circumstances, it would be more a curse than a blessing … if it helps prop up commodity prices.

Welcome to the dreaded vicious cycle, where expensive commodities contribute to destructive inflation, which leads to job losses that slow the economy even more, which forces the Fed to lower rates again ...

A student of economic and Fed history, Bernanke has seen inflation calming whenever a recession strikes the U.S.  It’s a valuable lesson and a leading reason why the Fed has chosen the course it has.  But because Europe is determined to hold rates steady and fight the threat of inflation, it could be the wrong lesson at the wrong time.

Good Investing,

Andrew Gordon

P.S.  To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com.

[Ed. Note: With a bear market looming, it’s more important than ever to select safe investments that produce monthly dividend income. Click here to learn about Andy Gordon's INCOME service that selects the best dividend-paying stocks available.]

Market Watch

Beware of “March Madness”

By Andrew Gordon

For company owners and CEOs, “March Madness” has a double meaning. There’s the “March Madness” most of us are familiar with, where the “best” 64 college basketball teams go head to head to determine who’s the best.

Then there’s the other “March Madness.”  And it’s not nearly as fun.  This is the month when companies open their books, year-end audits, and budget forecasts to lenders.  When times are good, as they have been until fairly recently, it’s not such a big deal.  But when times are tough and a company’s numbers and projections aren’t looking so good, lenders are more likely to lower the hammer.

That could mean anything from forcing a major restructuring … to forcing companies to accept new loans with onerous terms … to finding a buyout partner.  It also means banks will be more inclined to leave companies in the lurch.  Moody's Investors Service has projected corporate defaults jumping to 5.3 percent in 2008, up from less than one percent in 2007.

Investors need to be on their toes.  Companies with banks that have run out of patience could also see their shares fall.  How much and how fast depends on how hard the banks are coming down on them.

What’s more, it could easily bring more downward pressure on the markets, as if they need any more.  This year, March could beat out April as the “cruelest month.”

If you enjoy IDE's daily investing advice, you'll definitely be interested in checking out our sister publication, Early to Rise. Each morning, you'll get powerful wealth-building advice covering real estate, entrepreneurship, personal finance, marketing, and much more.
Sign-Up for Early To Rise today!