Publish date:

Few Deny We're in Danger Now

As foreign investors flee U.S. bonds, Fed faces the facts about the economy.

It may seem too little and too late, but U.S. and global central banks are admitting that the economy is at risk and that the summer's credit markets crunch may have broader ripple effects.

Behind cheers over new highs for many indices, the stock market has been reflecting this negative sentiment. Largely considered a proxy for U.S. economic growth, the Dow Jones Transportation Average has failed to make new highs with the rest of the market.

It peaked with the others on July 19, and bottomed with the broad market in mid-August when the credit markets seized up. But, instead of making new highs like its brethren the

Dow Jones Industrial Average

and the

S&P 500

, the Transports remain 11% below their July peak.

Executives at several of its component companies like


(FDX) - Get FedEx Corporation Report


Ryder Systems

(R) - Get Ryder System, Inc. Report

or trucking company

YRC Worldwide

(YRCW) - Get YRC Worldwide Inc. Report

have lamented declining shipping volumes and U.S. business strength as homebuilding trails off and imports fall.

Another proxy for strong economic growth, the small-cap Russell 2000 index, which has been a leader over the past four years, has likewise failed to make new highs in the post-August rally. It came close at the end of last week, but remains 3% below its July high.

The markets' anxiety about economic growth was echoed by central banks Tuesday, though some say their warnings are behind the curve.

"These are warnings Paulson and the


TheStreet Recommends

should have been making a year ago," says Richard Suttmeier, chief market strategist at and contributor to


investment ideas Web site. Suttmeier has warned for the past year that Federal Deposit Insurance Corporation data foretold the deep housing recession that's unfolded.

The Fed and the government seem to have underestimated the impact of housing on the economy, as they highlighted the risks of inflation as most pressing up until last month's Federal Open Market Committee Meeting. At that time, the central bank slashed the overnight rate by 50 basis points and dropped the hawkish talk to focus its energy on mitigating the financial market crisis that developed out of the mortgage market collapse.

Federal Reserve Chairman Ben Bernanke said in a speech Monday night to the Economic Club of New York that the housing market's correction will continue to be a "significant" drag on economic growth through 2008. He added that the Fed will monitor housing, business spending and the labor market to determine any further impact on the economy from tighter lending standards.

On the financial system, Bernanke said the 50-basis-point September rate cut "served to reduce some of the pressure in financial markets." He added that "considerable strains remain." The central bank will "act as needed to support efficient market functioning and to foster sustainable economic growth and price stability," he said to end the speech.

U.S. Treasury Secretary Henry Paulson chimed in later Tuesday morning during a speech at Georgetown University Law Center to say that the housing correction "is not ending as quickly as it might have appeared late last year, and now it looks like it will continue to adversely impact our economy, our capital markets and many homeowners for some time yet."

For many, these comments, combined with Monday's announced plan to help large banks like


(C) - Get Citigroup Inc. Report

avoid more writedowns due to illiquid and hard-to-price asset-backed securities owned by off-balance-sheet entities, means the Fed is going to cut interest rates further.

"Both the fundamentals and communication by Fed officials are still pointing toward further easing," writes Jan Hatzius, chief U.S. economist at Goldman Sachs. "Our best guess remains that the funds rate will fall to around 4% next year." The funds rate is now 4.75%.

But, perhaps the most troublesome of Tuesday's declarations came from abroad. The government reported that foreign investors unloaded a record-setting $69.3 billion of U.S. securities in the month of August. Many market participants didn't register surprise, as the credit and liquidity crisis gripped the world's financial markets most fiercely in mid-August.

But it would be foolish to dismiss the report as old news, says Brian Bethune, U.S. economist at Global Insight. It was not only a record, but the fourth straight month that China diversified away from U.S. Treasury bonds, fueling fears that the U.S. may have trouble financing its massive trade deficit. Japan was also a net seller in August.

The data also registered a massive increase in lending by U.S. banks to overseas entities -- which Bethune believes was connected to a shortage in U.S. dollar liquidity in European bank-to-bank lending markets. This was the confidence crisis that led banks to hoard their dollars and refuse to lend to each other.

"This is not the death-knell of trade finance," says T.J. Marta, fixed-income strategist at RBC Capital Markets. He claims that trading in Treasury bonds since August reveals that Asian buyers are back.

"But it is a reminder that there are big issues out there," says Bethune, noting that the outcome of the summer's drama was definitively a weaker U.S. dollar. "One has to be aware of the potential for a crisis of confidence in the U.S. dollar if there was another aftershock in the credit markets. That's the danger zone."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


to send her an email.