Debt Deleveraging Will Take Its Course

Big-3 Bailout?

The process of detoxing the debt-dependent, over-leveraged US economy continues to take its painful course and today the Senate will debate what to do about the flailing auto sector. Whether its consumers and businesses choosing to reacquaint themselves with saving and debt reduction or workers losing their jobs and being forced to reel in their spending, the US economy is necessarily gearing down. No matter how much taxpayer money the government throws at greedy bankers or inept auto manufacturers, the US consumer is not coming back to the table any time soon. Spurred on by the false wealth effect of inflated home prices and equity valuations, US consumers have been on a 10-year spending spree and US manufacturers, credit card issuers and retailers were only too happy to accommodate. The US economy has been producing way more cars (and trucks) and electronic gizmos and just about every other consumer product you care to name than what consumers could really afford to buy. The fact that the automakers, and others who have been feeding this consumer feeding frenzy, are now in trouble should not garner taxpayer sympathy. What on earth were these guys thinking? How could they not have better positioned themselves for the inevitable consumer retrenchment? The fact that the big three (only three) are in such trouble so early in this economic downturn suggests that they have not been viable businesses for a long time and it is foolhardy to throw money at them just to let them carry on for another few years. Let them go through chapter 11 and hopefully restructure themselves into profitable and sustainable businesses. The biggest cost component of a new GM vehicle is health care premiums for retired GM pensioners. GM, Ford and Chrysler are no longer viable businesses and must be allowed to restructure, as painful as that may be to shareholders and employees.

Global Market Remains Skeptical That Central Bankers Have It Right

The average US household is now carrying a debt load of 134% of annual income. We've seen stress fractures in the over-leveraged housing and auto sectors and are beginning to see problems with growing credit card defaults. The challenge that the government has is that consumers need to be encouraged to save and pay down debt levels. But, because consumer spending accounts for 70% of US GDP, there is no avoiding a recession if consumer spending slows. But there is little choice. The US government is running record fiscal deficits and that is only going to deteriorate going into a recession. The government is going to have to borrow from someone, and if it's not US consumers it will be foreign savers in Japan and China and elsewhere. The US will be much weaker economically if it significantly increases its reliance on foreign lenders through this recession.

So US consumers have to become savers and a long and deep recession is unavoidable. But how do you encourage saving when interest rates are so low? This is the missing link in this unprecedented coordinated central bank action to avert a global economic meltdown. At some point, either US interest rates are going to have to rise substantially enough to encourage saving and investing at home, or US foreign borrowing is going to soar and this will eventually weigh heavily on the dollar.

Certainly the gold market is betting against the dollar. It's interesting that gold is well supported above $700 and that it has only fallen about 25%, whereas other commodity prices are down as much as 80% since the commodity bubble popped in July. The price of gold is suggesting that the recent US dollar rally is going to be fairly short-lived because the US economy cannot afford higher interest rates given its massive debt levels. It is apparent that the Federal Reserve and Treasury are prepared to sacrifice the dollar as they endeavour to maintain low interest rates and reflate the economy. The dollar has had a nice flight to safety rally here but the longer-term secular downtrend for the dollar remains in play. It's just a question of when the dollar devaluation resumes.

Overnight Developments

Failure of the G20 meeting to produce any concrete measures to deal with the global recession has caused markets to continue to trade with a sell bias to start this week. Commodity prices remain soft, led by oil, which is trading almost $2 lower. Stock markets in Europe fell close to 2% and emerging market shares are trading 1.2% lower. Markets are expected to open lower in Canada and the US as earnings expectations continue to erode and risk premiums remain high. Japan reported that its economy shrank 0.1% in the 3rd quarter and Citibank announced that it would be cutting its payroll by 50,000 over the coming months.

US 3-month t-bill rates remain incredibly low at 0.1% and dollar Libor is holding around 2.24%. The US dollar is broadly lower this morning as most currencies get a bounce after last week's sell-off. The Australian dollar and the Euro are both up more than a cent and the battered British pound is trading almost four cents higher this morning. The Canadian dollar has recovered more than a cent from Friday's lows and looks like it wants to trade higher from these oversold levels. Should be another interesting week.