For certain, there is little pressure apparent in short term forecasts like the WSJ and Survey of Professional Forecasters. This makes sense (at least if one believes in the Keynesian conception of an output gap [1]) given the amount of slack displayed in Figure 1.

I also plot the median expectation of ten-year inflation. Note that this measure has not budged much at all.

This data, of course, will not convince those skeptical of survey-based measures. What about market based measures? The standard approach is to subtract the TIPS yield from the Treasury yield. We know for a variety of reasons, this calculation can lead to misleading results. However, the Cleveland Fed has stopped publishing its adjusted series:

October 31, 2008

We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.

With that caveat in mind, Figure 2 displays the implied ten year expected inflation rate.

Some people are looking to commodity prices as indicators of expected inflation. I'd say that making inferences this way is fraught with difficulties, because changes in such commodity prices will incorporate both relative price and price level effects.

So, there's little evidence now of inflationary pressures. That being said, there's plenty to worry about as time goes on (as Jim recounts). And even if inflationary expectations remain well anchored, we do have to keep an eye on possible crowding out due to higher interest rates (all of us, except Dick Cheney, who didn't ever worry about deficits as the Bush Administration ran up trillions in debt [3]).

• World stock markets tumbled Thursday, with benchmarks in Tokyo and Seoul losing almost 7 percent each. (AP)
• Five years after Federal Reserve Chairman Ben S. Bernanke helped stamp out the risk of deflation, the threat is returning as the financial crisis and a worsening economic slump pull inflation lower. (Bloomberg)
• The RBA said in a monthly bulletin today that it bought A$3.15 billion ($2 billion) of its own currency last month, the biggest net purchase on record, as the local dollar posted a record monthly decline.

• U.S. options trading slowed this month from a record pace after hedge funds collapsed and the biggest market swings since 1929 made equity derivatives too expensive to be used as insurance against stock losses. (Bloomberg)
Key Reports (WSJ):
8:30a.m. Initial Jobless Claims For Nov 18 Week: Expected: -11K. Previous: +32K.
10:00a.m. Oct Conference Board Leading Indicators: Expected: -0.6%. Previous: -0.3%
10:00a.m. Nov Philadelphia Fed Business Index: Expected: -38. Previous: -37.5.
10:00a.m. DJ-BTMU Business Barometer For Nov 8: Previous: -0.7%.

Quotable
“Early in life I had noticed that no event is ever correctly reported in a newspaper.”

  George Orwell

Best of CC: Below is a reprint of our 9 July 2008 Currency Currents where we examined the break down in the correlation between oil and the dollar—it was telling us something as we suspected.  It’s another example of why we pay close attention to intermarket correlations; it can be a very powerful tool for currency traders. 

FX Trading – $ vs. Crude…Hmmm! (9 July 2008 Issue)
Can we continue to hang our hat on the view that much of the bad news is already in the price of the dollar?  Well, based on the dismal views about the US economy, which we don’t dispute, which we seem to find everywhere we look, the short answer is yes.  But it’s not just that belief.  Something seems to have changed—though even this is a thin reed of reasoning we grant you.

Back in mid-April the US dollar index made its closing low (and its all-time low in mid-March, the day the Fed saved Bear Stearns).  At the time, crude oil was trading at $116 per barrel (heck, downright cheap in retrospect…LOL).  By now of course, everyone had caught on to the crude-$ connection that says the dollar goes lower when oil goes higher.  But, the problem with this new theory is that crude oil has rallied about $29 since mid-April, or a cool 25%!  However, the US $ index has rallied too—up 2%! 

Based on the crude-$ connection, that wasn’t supposed to happen. 

Chronology of key players’ recent trips to the Middle East (read Saudi Arabia):

• Vice President Dick Cheney – Mid-March
• President George Bush – Mid-May
• Treasury Secretary Hank Paulson – Late-May and Early-June

And on June 1, 2008 this from Reuters:

ABU DHABI (Reuters) - Treasury Secretary Henry Paulson said on Sunday leaders of Gulf oil producing states had told him that abandoning their currency pegs to the dollar will not solve their inflation problems.
Paulson, two-thirds of the way through a four-day trip to Saudi Arabia, Qatar and the United Arab Emirates, said leaders in the region have "quite an awareness that the peg does not influence inflation to a significant degree.
"They recognize that inflation is the overriding issue ... Ending the peg is not the solution to the inflation problem."

Hmmm…

Is it possible the Gulf States were treated to a litany of promises that the dollar was nearing a bottom and now is not the time to abandon said dollar pegs?  Again, we have no clue. But, it would be a nice fit with the ongoing lack of correlation between all-time highs in crude and the $ index cautiously trending higher.

Stranger things have happened.  Stay tuned. 

Regards,
Jack&JR

Can you give us some perspective on the seismic shifts we’ve already seen in trading this week?

While the strategic rationale for BAC to buy MER is pretty obvious - it weds the biggest retail bank to the biggest retail brokerage firm - what possessed BAC to pony up that sort of price is far from obvious. They could have had LEH for maybe $0.05 a share if they wanted it. If they had waited a week they could have probably picked up MER for $10 a share. I would not be shocked to find out that there was some sort of inducement from the government for them to step up the price, so there would be some "good news" for the markets today.

It also appears that the largest insurance company in the U.S. is now seeking federal protection?

Apparently the rule of law means nothing on Wall Street now. There is nothing in the Federal Reserve Act that would allow a non-Depository financial institution that is not even a Primary Dealer (and even that is stretching it big-time - but was the basis the Fed was part of the Bear Stearns [BSC] bailout/shotgun wedding) to have access to the Fed window, and certainly not to the tune of $40 billion which is reportedly what they are looking for.

This is crazy. There is no Fed window anymore. A window implies that it is something that could be open and shut, so that access to it could be controlled. This is no window, it is a gaping hole in the side of the wall. To the extent it is still a window, it is like all the windows of the J.P. Morgan Tower in Houston.

Many investors thought the market reached its low point with the Fannie and Freddie bailouts. Not so?

People thought that the demise of BSC was then end of the credit crisis, it was not. Then the conservatorship of Fannie Mae (FNM) and Freddie Mac (FRE) was going to be the bell that rings signaling the end of the credit crunch (big financial crunches have historically come to a climax when someone or something big goes under, like Continental Illinois Bank, Mexico, LTCM).

I doubt this is the end, either; there is still much more trouble ahead. In the meantime, hunker down and for God’s sake make sure you do not have more than $100,000 in any single bank. There are going to be a lot of bank failures still, and the FDIC insurance fund is running dangerously low.

Where would you focus your attention in this mess, near-term?

It appears that the next domino to fall may be Washington Mutual (WM). Its insured deposits alone far exceed the size of the FDIC fund. If it goes under there will have to be an emergency infusion of funds from the Fed or the Treasury. If that didn’t happen, then the next bank failure would result in insured depositors not getting their money back. That would lead to a run on virtually every bank in the country - shades of 1931.

Thus, I am very confident that such an infusion would be made. But - oh what the heck, what’s another $100 billion or so added to the budget deficit? Dick Cheney assures us that deficits don’t matter anyway.

So give us the big-picture, if you can – that is, if you have the stomach for it.

On a macro-level, what is going on is a massive deleveraging. Deleveraging is by its very nature deflationary. Money goes to money heaven when it happens. The Fed is trying to offset this by pumping as much liquidity into the system it can. Under normal times that is how you go about creating inflation.

Once upon a time, only depository institutions, plain old-fashioned commercial banks were allowed to borrow from the Fed, and then only using T-Notes or T-Bills as collateral. Then Investment banks were allowed in, and the collateral was expanded to Agency debt. Now it appears that even insurance companies can go to the window and use any investment-grade debt (and we know just how on top of things the Rating agencies have been about quickly reflecting the true financial conditions ) as collateral.

Heck, they are now even allowing equities to be used as collateral. What is next, a beanie baby collection as collateral? Down that road leads to hyperinflation (i.e. the United States of Zimbabwe). Theoretically, it would be possible to precisely offset the deflation with this induced inflation, resulting in stable prices. However, with the lags inherent in monetary policy even in the best of times (usually 6-9 months) and incomplete data collection, that will not be easy.

The best comparison I can make is that the Fed will have to thread a needle while sitting in a car going 70 mph down a poorly maintained dirt road, and they only get one chance. Stay away from the Financials. This is not over, folks.

Dirk van Dijk, CFA is the Director of Zacks Equity Research.
"WAMU" Free Stock Analysis: Buy? Sell? Hold?
Zacks Investment Research

While the strategic rationale for BAC to buy MER is pretty obvious - it weds the biggest retail bank to the biggest retail brokerage firm - what possessed BAC to pony up that sort of price is far from obvious.  They could have had LEH for maybe $0.05 a share if they wanted it.  If they had waited a week they could have probably picked up MER for $10 a share.  I would not be shocked to find out that there was some sort of inducement from the government for them to step up the price, so there would be some "good news" for the markets today. 

Meanwhile, it appears that the biggest insurance company, AIG (AIG) in the world turned down capital-raising offers from several private equity firms and is now going hat in hand to the Fed. 

Apparently the rule of law means nothing on Wall Street now.  There is NOTHING in the Federal Reserve Act that would allow a non-Depository financial institution that is not even a Primary Dealer (and even that is stretching it big-time - but was the basis the Fed was part of the Bear Stearns [BSC] bailout/shotgun wedding) to have access to the Fed window, and certainly not to the tune of $40 billion which is reportedly what they are looking for. 

This is crazy. There is no Fed window anymore.  A window implies that it is something that could be open and shut, so that access to it could be controlled.  This is no window, it is a gaping hole in the side of the wall.  To the extent it is still a window, it is like all the windows of the J.P. Morgan Tower in Houston. 

There is much to look at and explore.  Ten major banks have each come up with $7 billion to fund something that looks like a second, private Fed window.  As I write this the Dow is down 300 points.  If we close at these levels, count it as a victory. 

People thought that the demise of BSC was then end of the credit crisis, it was not.  Then the conservatorship of Fannie Mae (FNM) and Freddie Mac (FRE) was going to be the bell that rings signaling the end of the credit crunch (big financial crunches have historically come to a climax when someone or something big goes under, like Continental Illinois Bank, Mexico, LTCM). 

I doubt this is the end, either; there is still much more trouble ahead.  In the meantime, hunker down and for God’s sake make sure you do not have more than $100,000 in any single bank.  There are going to be a lot of bank failures still, and the FDIC insurance fund is running dangerously low. 

It appears that the next domino to fall may be Washington Mutual (WM).  Its insured deposits alone far exceed the size of the FDIC fund.  If it goes under there will have to be an emergency infusion of funds from the Fed or the Treasury.  If that didn’t happen, then the next bank failure would result in insured depositors not getting their money back.  That would lead to a run on virtually every bank in the country - shades of 1931. 

Thus, I am very confident that such an infusion would be made.  But - oh what the heck, what’s another $100 billion or so added to the budget deficit?  Dick Cheney assures us that deficits don’t matter anyway.

On a macro-level, what is going on is a massive deleveraging.  Deleveraging is by its very nature deflationary.  Money goes to money heaven when it happens.  The Fed is trying to offset this by pumping as much liquidity into the system it can.  Under normal times that is how you go about creating inflation. 

Once upon a time, only depository institutions, plain old-fashioned commercial banks were allowed to borrow from the Fed, and then only using T-Notes or T-Bills as collateral.  Then Investment banks were allowed in, and the collateral was expanded to Agency debt.  Now it appears that even insurance companies can go to the window and use any investment-grade debt (and we know just how on top of things the Rating agencies have been about quickly reflecting the true financial conditions ) as collateral. 

Heck, they are now even allowing equities to be used as collateral.  What is next, a beanie baby collection as collateral?  Down that road leads to hyperinflation (i.e. the United States of Zimbabwe).  Theoretically, it would be possible to precisely offset the deflation with this induced inflation, resulting in stable prices.  However, with the lags inherent in monetary policy even in the best of times (usually 6-9 months) and incomplete data collection, that will not be easy. 

The best comparison I can make is that the Fed will have to thread a needle while sitting in a car going 70 mph down a poorly maintained dirt road, and they only get one chance.  Stay away from the Financials.  This is not over, folks.

Read the full analyst report on LEH

Read the full analyst report on MER

Read the full analyst report on BAC

Read the full analyst report on AIG

Read the full analyst report on FRE

Read the full analyst report on WM

Umberto Quadrino, chief executive of Edison, Italy’s second-largest energy group, is lobbying the Bush administration to put its full weight first behind Edison’s ITGI Corridor project and, later, the more ambitious but still somewhat hypothetical Nabucco pipeline. Both would bypass Russia but transit Georgia.

"The Russians have demonstrated they can close that corridor through Georgia any time they want," said John Bolton, President Bush's former U.N. ambassador. U.S. officials reject that. "The Georgian energy corridor is safe," Deputy Assistant Secretary of State Matthew J. Bryza, one of Nabucco's major supporters, told an audience in Brussels Monday. He stressed that Baku-Tbilisi-Ceyhan and the South Caucasus Gas Pipeline, which transports Azeri gas to Turkey, were unaffected by the fighting. Mr. Bryza also said European energy companies behind Nabucco and the Turkey-Greece-Italy pipeline have told him they are determined to proceed with the two projects. "They haven't slowed down at all," he said. "They are anxious to line up gas supply contracts with Azerbaijan as soon as possible." But some analysts said the Georgian war could scare off investors, making it hard for the consortium to raise the €7.9 billion ($11.5 billion) needed to build Nabucco -- a task already complicated by the global credit crunch. Plans to expand Baku-Tbilisi-Ceyhan's capacity may also be in jeopardy. "This increases the risk profile enormously," said Jonathan Simpson, head of European projects at international law firm Paul Hastings. "Without the EU and the U.S. stepping in and subsidizing them, they won't get built. And so far they've shown no inclination to do that."