Pepto?

Wed, Jan 30th, 2007
2335 hrs

A well known past linear response to rate cuts was a rise in markets, led by
groups like the retails, financials etc. Fed cuts. Money is cheaper. Markets
rally. So, there! Don't fight the Fed. Old market wisdom. Easy!

No doubt money is cheaper now than it was this morning but as markets interlink
more intricately with each other through effects brought on by various financial
instruments, behavior to responses becomes very non linear, and sometimes
magnified ie., The distance between 1 and 2 may not equal 1 in all complex
systems, one such being the current global financial system. I'm sure the
"cognoscenti" that inhabit blogspace as well as financial media have pointed
out that the market declined today because of the ratings cut of a monoline
insurer. I'm confident that several years down the road, when we look back
at the events that have just transpired, a simple explanation like the one
above, or most others we can come up with at the current time will sound
positively ludicrous.

Capital can metamorphize into many forms - a collection of fine wines, watches,
cars, a glut of housing, consumer durables etc., The main point here is that when
you have a capital induced glut (regardless of its form) in the first place it
brings with it problems that may not necessarily be solved by economic impetus
that is intended to act in a manner to provide a buttress for further capital
spending - the malaise becomes interest rate insensitive. We've come down 1.25
percent within an eight day period and the yield curve has gotten a lot steeper
in a big hurry, helping banks in the process. The reduction in rates helps but
there are limits to how much the Fed can ease rates - there are concerns of
inflation, currency stability (dollar collapsed after the reduction) and the
iggest risk of all being that the foreign investor in hope of a return for
their money pulls the plug on external financing of the ongoing rise of the
US current account deficit. This Fed easing, at most, will put a sort of
temporary floor on the depth of this recession.

I speculate that we are now in the throes of the first real global crisis
created by the modern day creative financial securitization of assets. It is
likely that financial losses will spread from the sub-prime area, to prime
and onto all kinds of real estate, and then onto credit cards, leveraged
loans, corporate debt and the sort.

The poison pill here is that the pricing of exotic instruments created by
brilliant quants will have to be priced to common market. Remember the CMO
market in 1994? Here we have instruments of a sort, grouped into another of
a sort, and another of a sort, with each of the tranches having exotic
non-common market pricing systems. While the liquidity injection of the Fed
will help, the prevailing liquidity profiles of financial institutions will
play a pivotal role in the amount of counter party risk that is assumed.
Nobody really knows the sizes of the losses or where the losses might lie.

Economic slowdown will be more severe than is expected with the principal
trading partners of the US taking it on the chin....you get the drift!?

I am not formally trained in economic theory but what I did do when I was back
in school was spend a year with old microfiched Wall Street Journals going
back to the early 1900s and mapping out how things integrated into a whole. I
also read a whole lot of different economic texts. I don't understand what is
transpiring but I am very intrigued by what is. My safe way to navigate
through this is to trade in a manner consistent with past bear markets - sharp
rallies are to be sold and sharp sell offs are to be bought.

Where? Now, that's a different story. ;-)

You wanna Pepto?

- aLV

PS : All you had to do today was to listen to what Bill Gross (aka Bond GOD)
had to say after the rate cut. Closely!