The 25% plunge last week in the Baltic Dry index is not good news for those hoping for a mild recession in the global economy. The index measures the cost of shipping raw materials by ocean tanker and is considered a leading indicator of the direction of the world economy.
It could be a warning not to expect a sustained rally in stocks if and when policymakers stabilize the financial crisis. There may be no need to rush back into equities, just yet.
The silver lining might be that a weaker world economy could considerably reduce the odds of the tumble in the U.S. dollar, upward spike in interest rates, and/or galloping inflation that many fear will be the consequence of the U.S. government taking on an estimated $1 trillion (U.S.) in debt to rescue the U.S. financial sector.
As the Chinese economy ratchets down, the authorities will likely want to keep the yuan from rising even more so than before — so they should remain willing buyers of U.S. dollars and treasuries. They wont want to flee U.S. assets when it will cause the U.S. dollar to fall against the yuan and undermine their export-led, industrial development strategy. A preliminary signal of their willingness to continue supporting the U.S. dollar was the recent decision to cut interest rates.
Commodity-based economies like Canada and Australia will see weakness in their currencies against the U.S. dollar as the commodity boom fades further. And Europes regional differences are likely to be exacerbated, raising political conflicts that could undermine the euro on top of the regions more restrictive monetary policy that seems destined to produce a greater and/or longer lasting economic slump in the region.
And dont forget, the U.S. dollars status is not just about economics. For many countries, political considerations are paramount. Countries like Japan, South Korea, Taiwan and Saudi Arabia would not want to dump the U.S dollar and assets because of their security relationships with the U.S.
During recessions, lower risk appetite and flight to safety favors government bonds. Although the supply of treasuries will be rising in the U.S., so will portfolio demand especially considering how underweight many investors are. A Merrill Lynch study noted households currently have less than 0.7% of their financial assets in government bonds, about $1 trillion (U.S.) less than the peak of 4% in 1993. Public pension bond holdings are close to two-decade lows. Bond yields are low right now, even negative after adjusting for inflation, but as the economy winds down, inflation should be subsiding.
Admittedly, the debt obligations arising from the financial crisis — along with ongoing debt requirements for other government programs — are substantial and there should be upward pressures on interest rates. However, like in the 1980s, higher rates should be bullish for the U.S. dollar as foreign capital flows in, attracted by the higher yields. And slack in the U.S. economy may also allow the Federal Reserve to buy some of the debt without inflationary consequences, which offers some assurance the rise in bond rates should not be extensive.
History is an imperfect guide, but when the Resolution Trust Corporation began to buy bad assets during the savings and loan crisis in 1989, U.S. economic growth, house prices and equity markets did not bottom out for another 12 to 18 months. The dollar, however, traded sideways during the period