Stocks Stomped for Second Session in Succession

For the second day in a row, stocks took a massive beating on Wall Street. After retreating 1.6 percent in value on Thursday, the Dow Jones Industrial Average continued the ride to Hell on Friday, losing another 1.3 percent of its value. Both the Standard & Poor's 500 and the small-cap NASDAQ indices lost about a percent of their value on Thursday and another four-fifths of a percent on Friday as investors dumped big and small stocks alike in their rush for the equities exit.

Investors cashing in their stocks threw the proceeds at both long-term bonds and oil, with the prices of both rising as investors sought safety in guaranteed returns from government debt and strong upside potential in petroleum.

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Both debt instruments like Treasury bonds and commodities like oil offer investors more safety than stocks: Treasury instruments are guaranteed by the U.S. government, and oil is a physical asset with intrinsic value.

  Twice this past week, U.S. light sweet crude briefly crossed the $60 per barrel mark in intra-day trading before profit taking moved the price back south of what is emerging as a price break "neckline" at sixty bucks. Friday, U.S. light crude closed at a $59.84 per barrel on the New York Mercantile Exchange, the highest settle on record. With the price of long-term bonds on the way up as investors pump money out of stocks, the yield on the benchmark 10-year Treasury slid to just over 3.91%.

In recent weeks, bond prices had been steadily slipping, causing yields at the far end of the yield curve to move upward. This relieved many economists, who had been concerned over the past few months because,

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One danger of an inverted yield curve leading a recession is that the lower rates on long-term debt can induce increased demand for mortgage loans that later cannot be serviced because of falling household incomes during the economic downturn.

  when long-term yields fall below short-term yields on Treasury instruments—a phenomenon known as an "inverted yield curve"—a slowdown or a recession usually follows within a couple of quarters. Those fears had been allayed somewhat as the yield curve began to tilt upward with rising long-term rates; but over the past few days, the steady upward march of short-term yields has run alongside a resumption in the dipping down of the long end of the yield curve. At close today, the spread between the yield on a 10-year Treasury bond and that on a 3-month Treasury bill had narrowed to less than one percent.

As far as oil prices are concerned, two camps resumed a debate that began in earnest this Spring regarding the direction oil prices are headed over the intermediate term. Oil analysts for investment giant Morgan Stanley are saying that oil prices should start to pull back before too long; but analysts at rival Goldman Sachs are again saying that the recent run-up is just the wind-sprint on the haul all the way to as much as $100 per barrel.

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Adjusted for inflation, the highest price per barrel oil ever attained was at the beginning of the war between Iran and Iraq in 1981.

  In the event that the prophets at Goldman Sachs are correct, only the most stubbornly disconnected neo-conservatives would argue that the U.S. economy could take the beating on households and businesses without plunging into severe recession. The big question is whom to believe when it comes to prognostications about future oil prices. Right now, investors are racing into the oil markets because of relatively short-term factors like reports of limited supplies of oil in the early stages of the peak driving season, but deeper factors are at work behind the scenes. Global demand for oil is rising at a record pace, and the United States is only one part of this overall, possibly permanent adjustment of energy demand curves. With China's economy heating up, manufacturing and consumer demand there could literally swamp demand from most other countries around the world; and although the roaring economy in China might very well be getting its motive force from the early stages of a long-anticipated inflation spiral on the mainland, that changes nothing for the foreseeable future about the country's rapidly and aggressively escalating appetite for petroleum products to power a widening inflationary gap that the Chineses gerontocracy has yet to face in any meaningful manner whatsoever.

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In Keynesian economics, an inflationary gap has opened when the growth rate of aggregate expenditures in the economy exceeds long-term, "sustainable" growth rate of expenditures. This is caused by the growth rate of the economy's money supply exceeding the sustainable growth rate of real output.

  After years of printing the national currency, the yuan, at an excessive rate to hold its exchange rate at an artificially low level against the U.S. dollar, all of that excess currency should be starting to seep back into the Chinese economy, propelling an inflation spiral that would take the Chinese central bank draconian measures over a long and debilitating period of time to stop. It is unclear even to what extent the Chinese government grasps the danger of impending and rapidly escalating inflation, much less how it would handle the potentially devastating economic and political consequences of dealing with it. Regardless, however, of what lies ahead for the Chinese economy, there is no doubt that it has joined the big league of industrial economies soaking up fuel as fast as the world's refineries can pump it out.

Since early in the year, oil prices have see-sawed over a range that caused fuel and other energy prices to rise several times to worrisome levels. However, the U.S. economy was able to weather these fairly brief assaults on disposable income and net operating profits to keep going at a fairly healthy pace. If gas prices reach five dollars a gallon or more in a $100 per barrel oil market, businesses and consumers will be hard-pressed to keep from going into a full production and spending tailspin. Most political analysts would agree that Bush Administration officials, already adept at keeping a straight face while talking about how successfully the occupation of Iraq is proceeding, might soon have cause to use similar talking points as the U.S. economy slips into a quagmire of recession on one side and inflationary pressures on the other. How many Congressional Republicans who formerly supported the President's war but are now running for cover on that issue will choose the same level of loyalty if the economy craters is a matter of considerable speculation, given that all of this is happening on a timeline that intersects the national mid-cycle elections looming next year.