What Is Not Seen

In chess, when the king is trapped, with no exit, he’s checkmate, and game is over!

Now, looking down at the global economic chessboard, during the last couple of decades the U.S. has been wearing the crown. However, this time around Paul Kasriel at Northern Trust, believes that he might be checkmate. He writes:

Our base case economic scenario is that the U.S. economy entered a recession in early 2008, will remain in a mild recession throughout 2008 and will begin to experience an anemic recovery in the first half of 2009. The base case includes a sharp deceleration in inflation in the not-too-distant future as energy prices stabilize and then retreat due to a slowdown in the growth of global demand for energy. The Federal Reserve will maintain the federal funds rate at 2% through the first half of 2009. In the second half of 2009, when economic growth picks up enough to stop the upward trend in the unemployment rate, the Fed will start raising the funds rate.  

Our risk case scenario is that the U.S. dollar begins to fall precipitously coinciding with a rise in Treasury bond yields. U.S. inflation does not moderate because of the depreciation in the dollar. As a result, the Federal Reserve is forced to raise the funds rate even in the face of a rising U.S. unemployment rate. This would be “checkmate” for the U.S. economy, turning a relatively mild recession into a severe one. Why might the dollar dive? Because the U.S. Treasury is forced to issue more debt in order to recapitalize either Fannie/Freddie/ the Federal Home Loan Bank System/FDIC, and the rest of the world balks at being the buyer of last resort for U.S. government debt. As this is being written on Friday, July 11, a hint of this is happening. Rumors are swirling that the U.S. Treasury will have to recapitalize Fannie Mae and Freddie Mac. Rather than resulting in the usual flight-to-quality bid for U.S. Treasury securities, yields on Treasury coupon securities are rising and the dollar is falling. Another factor that could precipitate a further sharp decline in the dollar might be the severing of the pegs that foreign monetary authorities have maintained between their currencies and the U.S. dollar. The byproduct of these pegs has been upward pressure on the inflation rates in these foreign economies. If these monetary authorities can no longer tolerate this imported inflation and sever their currency pegs to the dollar, the dollar would likely go into a tailspin.