Foreclosures Preventing Quick Recovery Of Economy

June 2nd, 2008 | Tags: Foreclosures

As expected – the foreclosures are preventing a quick recovery of the economy from the verge of recession. It is following the path laid down by economy textbooks. The typical response to stress is to flood the economy with liquidity and that is keeping the financial system alive and offsetting the losses from the continuous drop in the real estate market. At this point of economic downturn the financial markets have an important role to play. Little wonder then that the average American feels that his or her retirement security cushion is intact enough to allow them to spend – although at a reduced rate.

The big question however is that will the stocks continue to hold or will the cosmetic mask expose reality below it? The stocks have climbed to near about 10% of the peak reached last October cushioning the effect of the near recession conditions. The buoyancy of the equity market relies on one factor – there is nothing else to be done! The Federal Reserve has done the only thing it can do – aggressive easing of money policies and yielding to Treasury bills that are equivalent to cash. The 90-day T-bills pay out a pittance of 1.8%. This is a sneeze compared to the inflation of 4%. All it does is to guarantee a loss of approximately $220 to every $10,000 invested. The same can be said about bonds. In fact yields from bonds are higher than cash equivalents – 3.8% for the long term ones and there are no risks.

If however inflation rises bond prices will tumble drastically. Right now the inflation-adjusted yields are little less than zero – a situation reached only twice since the last three decades. The bondholders are being told to be ready for 0% real return and bear the responsibility of future inflation.

Against this grim message stocks look attractive especially with equity market showing signs of being getting back on its tracks. Considering the magnitude of the bursting of the housing bubble, even caving in momentarily of stocks seems a good deal.

The optimism stems from the fact that in all likelihood the feds will not tamper the monetary stimulus that it has set rolling until perhaps next year.

The current picture is closely similar to what happened during the 1980’s. At that time short-term interest rates were kept low for extended periods and that helped the sick financial sector to recoup.