The Economy: Good News and Bad News

The stock market has reacted favorably to the European and American emergency economic plans launched over the weekend, with its biggest 1-day rise ever.

But as everyone knows, the stock market doesn't give the real picture . . . it only provides a superficial snapshot of investor mood (and - perhaps - a shove from the PPT).

So what is really going on underneath the surface?

Good News

BNP Paribas reports that the weekend efforts have lowered the inter-bank lending rate (LIBOR), the main indicator of a "liquidity crisis". As summarized by economist Nouriel Roubini:

Credit spreads start to ease:
- O/N USD LIBOR: 246bp down from 463bp (17bp pre-crisis);
- TED spread (3m LIBOR-T-bill spread) slightly down to 456 from record 463 earlier on Oct 13 after Fed announces unlimited USD liquidity (17bp pre-crisis);
- 3M USD LIBOR-OIS slightly down to 359 from 364 (10bp pre-crisis);
- 3M EUR LIBOR-OIS narrows to 182bp from 207 (10bp pre-crisis)

Moreover, the cost of credit default swap protection dropped for many European banks:

"Royal Bank of Scotland and Halifax-Bank of Scotland were two of the biggest improvers in credit derivatives markets Monday morning even as shares in both tanked after the finalisation of the UK government plan to inject both groups with fresh capital.

The falling cost of protection for most leading banks and insurers in Europe helped the iTraxx investment grade index to rally sharply, taking 6.3 basis points of the spread to 131.8bp, according to data from markit Group. This mimicked the wave of relief that swept stock markets broadly in Europe, although the dilutive effect of the measures on RBS and HBoS shareholders saw their stocks pummelled.

However, RBS led the way in credit default swap markets with its cost of protection dropping about 44.5bp to about 144.2bp, according to Markit, which means it costs €144,200 annually to insure €10m worth of debt over five years. UBS was next, 31.3bp lower at 185bp, while HBoS followed 31.2bp tighter at 155.8bp."

This shows that the bet-makers are somewhat reassured by the weekend moves, and believe that the risk of failure of these banks has lessened somewhat (it is not clear how much the nationalization of the Royal Bank of Scotland and other institutions affected the credit default swap rates).

Bad News

On the other hand, nothing has fundamentally changed concerning America's underlying economic problems.

This week, reports on retail sales figures, industrial production and housing starts will be released, and they will all be bad.

America is already deeply in debt and the various bailout schemes will increase our debt by two or more times.

America is losing its status as the world's reserve currency.

We have no real manufacturing base, haven't saved anything, haven't fixed the derivatives nightmare, and haven't decided to bite the bullet and go back to sound policy or sound money.

And forget the housing meltdown, there could be wholly-unrelated additional meltdowns on the horizon (see this for example).

Forecast

Because the fundamentals are getting worse, rather than better, my guess is that today's stock market rally is a several week long bear market bounce, and that there are more crashes ahead.

Investor euphoria over the flooding of money into the system by central banks will eventually give rise to disillusionment as the fact that you cannot patch a busted dam with water becomes clear.