Nine, Ten, Big Fat Hen

By: Chad Hudson | Wed, Nov 7, 2001
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Mortgage Refinancing Index

Will the tenth interest rate cut by the Federal Reserve work better than the previous nine? In order to answer that central question, one needs to believe that the previous cuts did little to stimulate the economy. While the economic data showed continued slowing throughout the year, was it better than what it would have been without the monetary stimulus? We have argued for a long time that not only was the U.S. economy in the mist of one of the biggest equity bubbles, or any bubble for that matter, but a more encompassing credit bubble that spread throughout the economy. The credit bubble unquestionably created an overall bubble economy culminating in late 1999 and early 2000.

It is important to remember that while there is a lot of talk by different pundits about how long the current downturn will last (can’t call it a recession yet, can we?), there has yet to be one quarter of declining consumption. This is quite notable since consumption is the driving force behind two-thirds of the economy.

Stephen Roach, chief strategist for Morgan Stanley, penned an interesting column last week. He argued that the current financial system gives consumers quicker and easier access to financing through home equity loans and refinancing. This in effect has eliminated the six to nine month lag in monetary policy that so many are counting on to hit within the next six months. By looking at a chart of refinancing activity, it is evident that the interest rates cuts had an immediate effect in January and again after the terrorist attacks. During the first quarter refinancings maintained an awfully high level. The Mortgage Bankers Association estimates that $700 billion worth of refinancings will be done this year, doubling last year’s level. Additionally, the MBA estimates there will $50 billion in "cash-outs," roughly the amount of the tax rebate checks. These estimates were made before the latest round of refinancing activity.

The next couple quarters are going to be interesting. Most pundits are calling for a recovery next year, but the expected rebound is staring to move from first half to second half. However, there is a significant risk to these projections. If Stephen Roach is right and the effect of monetary stimulus has already worked though and the current zero-percent car financing is pulling forward car sales, there is a very good chance that instead of the economy picking up next year, the consumer will be spent and consumption will start deteriorating.

This would obviously put a damper on any hopes of companies undertaking capital projects. Before any capital projects can be justified, companies need to believe they will have a return greater than the cost of capital. Granted the cost of capital has been falling with the interest rate cuts, but the inventory glut combined with overcapacity makes it difficult to forecast any project having a return greater than zero.

The economy’ worst case scenario is a Japan style liquidity trap. This happens when consumers or businesses are unwilling to borrow regardless of the interest rate. In Japan there is so little loan demand that banks are depositing excess cash in other banks. Interest rates are so low it is barely worth it to keep money in the bank. Everyone should be comforted by knowing that America has too much inflation to fall into a liquidity trap. Since Japan is experiencing deflation it is prudent for them to hold cash and defer purchases. Looking at a recent M3 chart, some should watch what they wish for. A period of deflating asset prices combined with inflating goods and services would clearly be a very difficult situation to correct. How likely is this scenario? Enough to be unsettling. Right now the U.S is the world’s largest debtor nation and produces very little. At its peak Japan was the world’s largest creditor nation and actually produced goods. After its bubble burst the Yen experienced a drop of almost 50%. Again, it OWNED the paper of other countries. Just think how much worse it could have been if foreign investors held Japan’s debt and decided sell.

The booming economy even penetrated professional sports. Corporations have had money to burn for advertising and skyboxes. This sent values for teams skyrocketing and fed expansion for all major sports. Actually, the expansion of professional sports is not unlike corporate America. As the good times rolled on leagues expanded and costs ballooned with higher salaries and additional capital expense in the form of new stadiums and arenas (with a lot of tax payers footing the bill). Now major league baseball admitted that it too suffers from overcapacity. Owners today voted to eliminate two teams from the league, and several owners were pushing for two more teams to be eliminated. Corporate America has priced out the regular fan out of professional sports and team loyalties have been damaged. With corporate America scaling back "frivolous" spending, the elimination of sports teams could turn into a trend.

One of the quickest reductions in capital spending came from Qwest this week. Qwest ordered all vendors to "stop all work being performed in the network" immediately. Any contractor that did not cease immediately jeopardized future business with Qwest. Any equipment that was not installed was not going to be paid for, and Qwest froze any equipment shipments. Just a few days before, management reaffirmed its full year capital expenditure plans of $8.5 billion. Qwest also said its capital expenditure for the first nine months was $7.8 billion, and $2.2 billion was spent in the third quarter. It does not take higher level mathematics to determine fourth quarter spending will only be $700 million. Since it was already one month into the quarter and $700 million is about the run rate Qwest had during the third quarter, the drastic action is not surprising.

Airlines continue to bleed cash and have already used up most of the tax-payer money given to them. In a story by the Wall Street Journal, Tom Horton, chief financial officer for American Airlines, said, "We’re losing millions of dollars a day, and I don’t see an end in sight." Airlines are getting squeezed from both sides. Revenue is down as fewer people are flying and reduced fares are having little effect in stimulating demand. The easy cost cutting has already been done, and additional cost cutting will have greater ramifications than caviar not being served in first class. Cutting additional flights will start impacting connecting flights and throw entire logistical plans into turmoil. It is getting more and more obvious that the airlines need to eliminate their bloated cost structure either through bankruptcy. Merging operations could be an option, except I’m not sure any are strong enough to absorb another company, especially another ailing company. Another thorn in the airlines is the recent labor contracts signed with the different unions. During the 90s airline labor cost have increased 79% while passenger revenue grew only 60%.

For those looking for inflation, UPS announced it will hike rates an average of 3.5%. Interestingly, as oil has fallen to the lowest level in two years, UPS is keeping the 1.25% fuel surcharge implemented during the energy crisis last year.

Corporate profits are going to come in at the lowest level in several years. One consequence of low corporate profits will be reduced year-end bonuses, if not eliminated altogether. Eastman Kodak doubts it will be able to pay its annual "wage dividend" this year. It would only be the second time since the company was founded in 1899. The other time was during the Great Depression in 1934.

In the adding insult to injury department, Valiant Networks, a San Jose telecom consulting firm, is asking its laid-off workers to payback a portion of their signing bonuses. After working for Valiant for six months, John Schuett was laid-off and now Valiant sent a letter asking for $2,500, or half his $5,000 signing bonus.


Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis

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