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Saturday, June 27, 2009

Deflated Expectations

A traveler wandering through the desert spots a watery oasis. He moves toward it in hopes of quenching his thirst and taking a dip in the cool clear water. It's only a mirage of course, but in the traveler's mind it clearly exists. His belief in the mirage is strengthened by the only thing he has to hang on to. Hope.

Financial markets have recently been influenced by hope. Hope that the recession will end soon. Hope that the worst is behind us.

After an apocalyptic fourth quarter, the first half of 2009 resulted in a rather beefy improvement in equities with speculation (aka hope) that the recession had bottomed out and that there is light at the end of the tunnel. Interest rates rose in May and June as government debt soared and a new fear took hold, inflation. But is that fear real yet? Isn't our immediate fear deflation?

In the long term, the massive government spending that is taking place no doubt will have negative effects, but in the near term, deflation is the enemy. Starting with real estate, the value of assets has declined the past couple of years. Bank lending continues to decline because it is foolish to lend on a declining asset. This is evident in the Fed's weekly H.8 report which shows that bank credit actually fell $59 billion last week, and fell $83 billion over the past two weeks. Without credit, markets for these assets are stifled. And the negative loop continues.

Until credit loosens, inflation cannot appear. So in the near-term, deflation and low interest rates abound. The benefactors in the second half of the year will continue to be first time home buyers who can now afford homes (which values have deflated) and qualify for loans at low interest rates. Also, the handful of homeowners who still have equity in their homes and can take advantage of refinancing.

So with every bit of bad news, there is a silver lining. Low interest rates are what we have to look forward to for the second half of the year.