Now For The Hard Part...

The past couple of weeks have felt vaguely comforting: stocks rose, some economic data, both here and abroad, seemed a bit less dire than it could have been, the government appeared to be getting a handle on the banks and - more importantly - came up with a plan for regulation of derivatives that finally showed leadership, ditching the fiction in place since 2005 that industry-led efforts would be sufficient to ensure proper market functioning. After the ravages of the post-Lehman months, the global economy heaved a sigh of relief.

But the relief won't last. Already, the first signs of problems (slowing Chinese exports, plunging U.S. retail sales, desperately bad numbers from the euro zone, not to mention a realization that the banks remain a possible source of more instability) are hurting sentiment. We're now finding out that the landscape at the bottom of the cliff is not exactly a hospitable place. It's strewn with large rocks, and it's very hard to see what lies behind those boulders. It's not at all what we are used to - as citizens, investors and policy makers. It's one thing to see a slow, gradual recovery - that at least implies progress, even if only at snail's pace - and devise policy accordingly. It's another to plot policy for a course that goes round in circles at times, heads up, then down again, and occasionally runs into dead ends.

But critics of the massive deficits and the Federal Reserve's monstrously inflated balance sheet have smelled blood. It's true the Fed and the government are taking a massive gamble, and if things don't pan out, the fallout could be extremely painful for many, many generations to come. But those who want the Fed to start shrinking its balance sheet and the government to cut spending now live in cloud cuckoo land. They fail to understand how much leverage still has to come out of the U.S. system - not just at banks and households, but also at corporations (remember, the years preceding the crisis saw massive LBO activity, shareholders clamoring for buybacks, and several mergers - not just in the auto industry - that shouldn't have happened.) The global economy is showing extreme strains as it tries to adapt to U.S. consumers' new-found frugality. The tried and trusted method of exiting a recession through exports doesn't work in a world where financing is scarce and demand even scarcer.

We must not forget that this is a financial and an economic crisis - on a global scale. In this case, the past is really no guide to the future. Storm clouds are already gathering once again - it's another two weeks to June 1, the deadline for GM. Even if the U.S. economy manages to weather that event, it would be premature to think that our problems are over. The inflection point spied by some policy makers could yet turn out to be but a short-lived reprieve.

Don't Trample The Green Shoots

So the Fed held fire on expanding the Treasury purchase program Wednesday - but there's one thing one shouldn't overlook: the program runs until the fall - ie September. So either at the June or the August FOMC, it'll have to make the decision whether to expand its buying.

In the meantime, there's plenty of bad news lurking that could prevent a full-blown, sustained sell-off in the long end of the Treasury market - even though the 10-year yield could well test the 3.25% mark before all is said and done. Right now, the market is obsessing with supply - no wonder, Treasury said Wednesday it plans to sell some $361 billion in marketable debt this quarter. That's after just over $450 billion or so were sold in the first quarter - $2 trillion is easily in our sights if we continue at this pace.

Among the risks still out there: the fate of the auto makers. The Chrysler negotiations are going down to the wire - and we're only talking $6 billion or so in debt involved. In the battle royal over GM, bondholders have just fired their first shot, according to Reuters. Investors may think that with GM bonds trading at just a couple of cents on the dollar, all the bad news should be already priced in. But last week's swift drop in the dollar against the yen, when the bankruptcy flag was raised for Chrysler, was a healthy warning against complacency.

More uncertainties: the banks. From Goldman Sachs to Deutsche Bank, their first quarter profits came overwhelmingly from trading - fixed income, currencies, commodities. Not even the banks themselves think that's a sustainable model of growth. Not to mention the stress tests, the release of which is turning into a painful farce.

The biggest question mark, though, hangs over the economy, and the consumer in particular. There's a lot stacked up against us (see above) domestically, while the economy slowly wends its way out of recession; the highs in the jobless rate have yet to be seen. Foreign demand won't be much help - the economies in Germany and Japan look likely to have a terrible year.

A closer reading of the Fed statement shows that while policy makers are less downbeat than in March, they remain closely attuned to the risks to the economy. Policy makers are determined to keep long-term rates, so important to consumers and the housing market, low. The consensus that the Fed will expand its Treasury purchases will likely prove right. Now all we need to work out is when they'll tell us.

A High-Stakes Gamble, In China and the U.S.

A long post on China Financial Markets brings a timely reminder not to get too euphoric about the recent turbo-charged economic numbers - everything from bank lending to car sales took a big jump in the first quarter - regardless of the official cheerleading. Key to whether China's economy is really recovering is whether all that money is creating jobs. Hard to know - but as the blog points out, even among officials there is the realization that the stimulus plan's impact could be temporary and a second round could still be necessary.
Meanwhile, in the U.S., talk of a second stimulus package - mooted as recently as in February - has all but withered away as the economy appears to have stopped falling in a straight line. That's no grounds for complacency, though - while China might see a W-shaped recovery, the risk in the U.S. is an L-shaped one (though U remains the favored forecast, for now).
China needs, as CFM notes, to see more private than public sector growth - but that doesn't seem to be happening, if the numbers quoted are correct. It still needs a prospering export industry, even as it seeks to reduce its dependency on foreign demand and become more reliant on domestic consumption. All the while, there's the issue of its massive foreign exchange reserves and how to manage them.
The U.S. problems are just as daunting: it has to do the reverse of the Chinese - reduce consumer demand and become more competitive in the global market place; it also has to reduce the share of its financial industry (which even last year accounted for 28% or so of domestic corporate profits) in the overall economy and find something to replace the lost business with. As consumer demand shrinks, Americans' reliance on debt should also diminish - doing away with the need for the securitization markets which lie at the heart of the financial crisis and which the authorities seem hellbent on restoring - even though if we've learnt one thing, it's the fallacy of the grandiose notion of democratizing credit.
The point is this: the Leviathans of the global economy - China and the U.S. - are both facing wrenching structural changes. Both governments are working on making the changes bearable and limiting the pain to their populations, but let's be realistic: it's a high-stakes gamble - there are no blue prints; plus the sobering thought that the last time we got out of a similar economic desaster, the world was engulfed in warfare.

Spring Blandishments

Spring's here and with it comes talk of "green shoots" and "small signs of hopes" when it comes to the economic data - February brought the second month in a row of rising retail sales and personal spending, durable goods orders were up as were existing and new home sales. And bank chiefs talked about a good start to the year for the first two months.

But it pays to remember that the on-month gains came after the economy well and truly tanked in the fourth quarter - it fell so steeply, there had to be some kind of leveling off in the pace of decline. That's no doubt a good sign; a continuation of the fourth quarter's precipitous drop across all sectors of the economy would have been highly alarming. But when things stabilize, there's still a possibility they could resume their decline - it's in no way a given that the only path from here is upward. And in a worrying sign, some bank chiefs, including JPMorgan's Jamie Dimon, are warning that March was a tough month.

The coming week brings the first inklings of this month's data in the form of the ISM's national reports on the manufacturing and non-manufacturing sectors. The headline numbers will show more stability, but it's the components such as inventories, shipments and orders - particularly export orders - that will be the most insightful. Global demand outside the U.S. has collapsed - the major export nations, from Japan to Germany to China, have all reported dire export numbers. Chinese officials believe they have averted crisis with their stimulus package and that the vital signs of their economy - such as bank lending - have improved. Germany says it has done enough to stimulate its economy and that given its high debt levels - left over from the country's reunification in the 1990s - it doesn't have the fiscal flexibility to spend more.

But demand will have to come from somewhere for the U.S. economy to start growing and not just bump along the bottom of the trough for an extended period. The domestic stimulus package is one source - but that won't come into full force until 2010. Foreign demand will take even longer to surface - China's recovery will to some degree depend on a recovery in the U.S. as one of its largest trading partners; Germany needs the rest of the world to recover so it can start exporting again, and Japan's economy remains in a blue funk. A hopefully more immediate source of demand will come from the funds that the Fed is creating and throwing by the armload at financial markets to revive gun-shy capitalist spirits and the broader economy.

Spring crocuses notwithstanding, the economic outlook continues to hang in the balance. It will take longer than one season for the rescue efforts to work their way through the economy.