Steve Blitz Morning Notes

Census reported on monthly trade in February and not surprisingly the deficit is a lot smaller than it used to be because import demand is quite a bit lower (see chart). The non-oil trade deficit has been shrinking since March 2007 and the turn in trend coincides with the beginning of the implosion in securitized products. The two events coincide but it is no coincidence (see chart of non-oil trade deficit vs two-year swap spread – my proxy for bank credit stress).

The flip side of a shrinking trade deficit is reduced foreign capital inflows to finance the deficit. Once the growth in the bid for these instruments ebbed, supply exceeded demand and traders and investors knew that these instruments were no longer going to be priced against the momentum of surging demand but against now weakening fundamentals – the rising tide of subprime mortgage defaults. Existing holders of these securities recognize a depreciating asset when they hold one and when they tried to sell it the “Street” showed no bid – no surprise. And we all know how the story unfolded from there.



The non-oil trade deficit is now shrinking even faster but the two-year swap spread has narrowed and seems relatively stable around levels generally consistent with recessions. The sum of the efforts by the Fed and Treasury to reliquefy markets is apparently working. In truth, they have been effectively replacing diminished foreign demand with government capital.

In the past several months the sharply narrower trade deficit reflects a sharp collapse in import demand (all of this is looking at non-oil trade flows). Recessions do that and do it fast when consumption drops off as rapidly as it has. It is no surprise that the economies of our trading partners turned sour at the same time – although it was a surprise to the FOMC based on the minutes released yesterday.

The drop in imports and narrowing trade deficit are why there is a huge ongoing adjustment in the U.S. capital markets and in nations manufacturing our imports. Moving forward is where policy gets tricky if a sustainable recovery is to be engineered. Policy needs to accept and manage the deleveraging of the U.S. economy. If economic policy instead focuses on supplanting private credit with government funds and keeping the dollar strong then policymakers here and abroad are just trying to put humpty dumpty back together and back up on that wall. By doing that policy is setting up humpty dumpty for another fall.