Bank Troubles

The Fed threw a party and nobody came. They surprised the market with a full 50 basis point cut rather than the consensus 25 basis points. To ease fears that the economy might be really bad the important bias was changed to neutral. The private banking system did not follow with cuts to the prime-lending rate. The market had a muted response to the rate cut. The next day it turned into a rout as the Dow Jones Industrials fell almost 200 points. The downward trend continued on Friday.

I don't know what the market was really expecting. Over the past year or two they had cut the rate 11 times from 6% to 1.75% and nothing happened. At times there was some hope that things might be improving but at best the market response was lethargic. At worst the market wasn't buying and we continued to new lows, the last one being made on October 10.

So easy Al comes to the rescue once again to try and give the market a fix. But like a junkie or an alcoholic the market needs an increasing fix or it just doesn't work. And then it hits the point where you keep giving it its fix and nothing happens. Things instead get worse. We are now starting to enter that stage.

Over the past few months I don't know how many analysts I have heard say, "No, there will be no double dip recession". So what is happening? Well we are headed for double dip. Expect them now to come out and say it will be short lived and 2003 is looking downright rosy. Indeed my morning paper told me that the Bank of Montreal was predicting that with beefed up business spending next year the Canadian economy would grow by 3.8%. I wish them luck.

The 50 basis point cut (which was unanimous) even seems to fly in the face of the Fed. In earlier testimony Fed Chairman Alan Greenspan had constantly referred to the effectiveness of the consumer and his continued spending and the buoyancy of the housing market. Then consumer confidence plunged; mortgage foreclosures ran at a record pace; spending dipped (personal consumption); and, consumer debt rose even more. So this 50 basis point cut is quite worrying as it is saying things are not well. But if 11 earlier cuts were not working then what is the 12th cut going to do? Well I suppose there is still 1.25% to go.

But the actions of Mr. Greenspan are not surprising. I read recently in an interview with Ian Gordon of Canaccord Capital, a proponent of the Kondratieff Wave Theory where he recounted a story that Alan Greenspan had told a colleague years ago that he would "love to be Fed Chairman when the Kondratieff Winter comes because I think I could override it by dropping interest rates and printing enough money that it would overcome all the deflationary aspects of economy".

Well he is getting his wish. Only it may consume him. Trouble is these things are unpredictable. The bubble of the 1990's was huge even compared to the bubble of the 1920's. So the correction in the Kondratieff winter should be just as severe. The final shoe that needs to drop is the debt collapse that will force the economy into deflation.

The consumer may now be borrowing from Peter to pay Paul. In the month of September consumer credit (US) rose by a higher than expected $10 billion. Trouble was that personal consumption fell 0.6% in September, the first decline in 10 months. So the question begs, where did the money go if not on consumption? 0% financing rates for automobiles is now resulting in sharply falling sales for the automobile companies. There is only so many cars that the consumer can own. And he may now be at his limit.

And mortgage refinancing may also be tapped out. Since mortgage-refinancing rose sharply over the year as well as consumer credit it tells us that mortgage refinancing was not going to pay down other debt, it was going to consumption. Once that money runs out where does the next fix come from? The Fed obviously hopes he can keep the cycle going with this latest 50 basis point cut plus continued growth in the money supply (M3) that has expanded at an 8% pace in the latest three month reporting period. What if that doesn't work?

While easy Al can cut his rates it is the banks and financial institutions that must lend the money. And the banks are clearly under pressure. The Toronto Dominion Bank (TD-TSX) shocked the market by announcing a second massive and unexpected increase in loan-loss provision in just over three months.

The Telecom sector was plaguing TD earlier. This time it was the power generation sector. We need look no further then our own woes with Ontario Power Generation and soaring electricity bills to realize the disaster that is waiting in that market. Much of it had to with the massive losses in the power generation sector since deregulation. The TD raised its loan loss provision by an additional $750 million bringing the total for the year to $2.1 billion. Other banks were expected to follow although all of course denied it. At least TD is recognizing it quickly. Sadly there may be more to come.

But the problems in the banking sector don't stop with the Canadian banks. J.P. Morgan Chase (JPMNYSE) had to deny rumours that it had suffered large losses in its derivatives portfolio specifically in gold derivatives. Rumours were flying that the losses were anywhere from $17-$70 billion! Yes that is billion. J.P. Morgan Chase of course is the bank of the $23 trillion derivatives portfolio. Morgan is also being blocked in trying to recoup insurance related to losses on the Enron debacle. You can collect on losses but not fraud. Morgan may have lost about $1 billion on Enron. And don't forget that Morgan also was a major lender to Global Crossing, K Mart, Argentina and more and more and more. If Morgan were the only US banking institute in the US experiencing problems it would be one thing but all of the majors including Citigroup and Bank America are also under pressure.

Clearly what we could soon be heading to is an outright credit crunch. Analysts were almost unanimous that there could be more provisions to be provided for by the TD. And then there are still the other banks here in Canada, in the United States, in Europe. Many have seen their credit ratings downgraded reflecting this reality. Review and a significant pull back in lending is getting underway at all banks.

For the Corporations it is even worse. With the credit situation deteriorating at the banks, credit spreads between government treasuries and the corporations have been widening. This is making money more expensive to borrow and forcing many to try and come to market with stock issues. Many major corporations are now finding themselves severely under funded for pension obligations. This impacts them negatively and impacts earnings going forward. But issuing more stock will just put further downward pressure on their stock prices.

When the credit crunch comes the economy will come under severe deflationary pressures, as debt is unwound and loan losses mount. No amount of Fed cuts can stop this avalanche once this gets underway. It is just beginning to get some steam but it could take more than a few years to play itself out with many fits and starts. And now the US dollar is beginning to break down again as well. Europe left interest rates unchanged.

This leaves interest rate differentials between the US and Europe more favourable to Europe. The US dollar index has fallen under 105. The Euro is back up to 1.01. In a consumer society such as the United States a falling dollar is not good. They have trade deficits that average about $35 billion per month. As the cost to import rises demand will fall, putting further pressure on the US economy and ultimately on US interest rates as they may be forced to increase rates to defend the dollar.

Finally the UN approved a new resolution against Iraq. This moves us one step closer to war even though there is nothing in the new resolutions that authorizes the US to invade without first going back to the UN. Curiously the US already has upwards of 50,000 military personal in the area with the attendant large buildup of weapons and supplies. The US is preparing to go to war no matter what. This brings another element of uncertainty back into the equation and could still see the US act unilaterally.

With growing banking troubles and uncertainty in the market place once again it is surprising that the market has held up so well since the lows of October 10. But this has been a technical rally. With no further rate cuts expected and little impetus to boost the market going forward new lows for the year may soon lie ahead. Of course another save could come in and keep this market up into the US Thanksgiving holiday. But that scenario is looking shaky now and if the rumours coming out of Morgan are only half true then the market is in for another shock.

We are leaving you with a picture of four financial stocks. The similarity in the weekly charts of TD Bank and J.P. Morgan Chase is striking even though Morgan has been the weaker of the two. But this past week both turned down sharply failing at the 50-day moving average (not shown). The 40-week moving average of the TD is beginning to cross the 4-year moving average. The same average crossed months ago on Morgan. This is indicative of a long term weakness that will not be resolved overnight. Both these banks should be avoided.

Our second chart shows two that for comparison sake have been relatively strong. The Royal Bank of Canada (RY-TSX) has been by far the best performing Canadian bank stock. Indeed the chart remains relatively bullish. But it could be indicative as well of a long term topping pattern. The Royal is holding above its 40 week MA and has been the only Canadian bank to do so. But if the rest of the industry is suffering Royal will not escaped unscathed. A failure to make new highs here followed by a drop under $50 will send it to the 4 year moving average.

Fannie Mae (FNM-NYSE) is the largest mortgage lender in the United States. With mortgage foreclosures at record levels and the housing market boom beginning to falter this is bad news for Fannie Mae. It is falling down out of long topping formation. It is now under its four -year moving average and clearly ran into stiff resistance at that level near 70. This is a picture of what should soon befall the Royal Bank.

The banking sector is a key to the economy going forward. The Royal Bank chart is about as good as it gets in the sector. With banking troubles just beginning to come to the forefront it bodes poorly not only for any recovery but the market going forward. With the financial sector's participation it is highly unlikely the market can muster much of a response. We have been warning on this sector for months. The debt situation needs cleansing and the banks are at the forefront of it. And all the Fed cuts and money injections in the world can't save it.

Charts and technical commentary by David Chapman of Union Securities Ltd. 69 Yonge Street, Suite 600, Toronto, Ontario, M5E 1K3 (416) 604-0533, (416) 604-0557 (fax) 1-888-298-7405 (toll free) email [email protected]