Since the yield curve is inanimate, it feels no emotions. Its predictive capability bears ZERO relationship to what anyone may think of it. We, on the other hand, do have emotions. We try as hard as we can to set them aside in analyzing economic, financial, and market phenomena. We will admit, however, to a fondness for the yield curve. Reason: it has been an outstanding forecaster. Its prescience contrasts with the ineptitude of the generality of economists and Wall Street sages; it is crystal clear, in contradistinction to the compound jargon and contrived murkiness of economic forecasts; and, it is not in the slightest bit demagogic, as it makes no appeal to our emotions.

The yield curve has in recent years lost its following among "professional" economists and Wall Street "seers." We attribute this to the fact that the structure of the yield curve has frequently sent a message no one wishes to hear. This message, as even the most ardent detractors and ignorers of the curve must now admit, is being vindicated with greater and greater emphasis with the passing of every day.

We note the continued sharp divergencies within the equity market insofar as valuations are concerned. As we have opined before, there are a number of very high quality equities which are very undervalued relative to their historic valuation ranges. At the same time, equities in economic sectors which are going from bad to worse, while attractive on their face, are increasingly dubious in the context of a sharp decline in future earnings implied by the deepening credit contraction. In point of fact, the measure of absolute valuation (p/e ratio) is contingent upon the actual earnings which will in fact materialize in coming quarters. It is the rising probability of a serious overall earnings contraction which has raised the risk level of the overall market very substantially, in our view.

Leaving aside for the moment the reality of two economies and two markets, which we continue to embrace, we assess the respective cases of the bulls and the bears in the CURRENT AND UNFOLDING ECONOMIC CONTEXT AS FOLLOWS:

--The bulls maintain that valuations are very attractive relative to historic norms. Their hypothesis is that the economic weakening underway will NOT develop into a serious recession. Indeed, many in the bullish camp assert that the economy is having a "soft landing" and will avoid recession altogether.

Negative.

We define a panic as a mass, emotion-driven herd movement,catalzyed into motion and exacerbated by IRRATIONAL FEAR or a movement characterized by an IMPROPER RESPONSE TO RATIONAL FEAR.

Since we regard the FED's acute -- albeit rather late-blooming -- FEAR -- as being soundly based, we cannot label the FED's sudden and dramatic rush to monetary accommodation as PANIC. What it in fact constitutes is a very belated recognition of the serious deflationary threat which exists and is worsening, and which it previously found it convenient to ignore.

As the reported one vote short of unanimity on the FOMC for dramatic rate-cutting demonstrates, the camp of the die-hard inflation-phobes at the central bank has TEMPORARILY been reduced to one.

We predicted, some months back, this dramatic reversal in FED policy, and the forthcoming ascendancy of fear at the Central Bank. This forecast was made at a time when the FED was glorying in its steely anti-inflation determination and in its confidence in its own wisdom and its ability to keep the economy on track and contain the sub-prime crisis with fine words, symbolic action, and a stern refusal to produce liquidity. We predicted at the time that market and political pressures would reach a point where they would overwhelm the FED, and crack its anti-inflation resolve. Well, that day is here.

Well folks, our impressionistic read on what Wall Street currently likes and dislikes -- insofar as this is reflective of where the "smart money" is ALLEGEDLY GOING -- looks to us like this:
-- Treasuries are OUT. They are too high; yields are too low. Supposedly, the "smart money" has been moving out of Treasuries and into Fannie and Freddie mortgage securities, as well as high quality corporate bonds;
-- Hints abound that high yield bonds -- i.e., JUNK -- are looking good. We are told, again and again, how far up yields have gone, how much spreads between junk bonds and Treasuries have widened, how attractive junk is;
-- Banks and other financials are CHEAP. They always lead the market when the FED cuts rates; every dummy knows that, don't they? Besides, look how much they have gone down. Plus, rescue operations are underway. Smart money is getting in now, ahead of the herd. Get with it guys!
-- Retailers. Yep, buy when everyone hates 'em. Today there is major piece in an eminent organ of financial respectability on how smart money is moving into retailers.

The bottom line -- you can get ahead of the herd if you act now, following in the footsteps of a lot of smart money!

Of course, there may, in our humble opinion, be a couple of jokers in the deck.

Several months ago, shortly after the inception of this blog, we forecast that the flood of sunny assurances from the FED and from the economics fraternity, as well as the compulsive hand-wringing about "Inflation" and too much growth would give way to a new focus: recession. In this prediction we were correct. Now, we will venture forth with yet another prediction. We expect that before too long a word which has seemingly disappeared from the lexicon of "analysis" and "reportage" will be making its return from near-death.
This word: DEFLATION.

The tendency to analytical myopia and to obsessive fixation on the "issue" of the day to the virtual exclusion of all else is a hallmark of contemporary financial and economic and Wall Street commentary, as well as the heretofore more sacrosanct pronunicamentos from the FED. This propensity oversimplifies, and generally distorts significantly, the analytic picture. So it is with the absence of the word DEFLATION from the current dialogue, if one chooses to dignify it with this word.

A simple question deserves a simple answer. We will pose our simple question, without any hope whatsoever that we will receive any answer, simple or otherwise.

Our simple question is this: What are BANKS doing gambling with tens or hundreds of billions of their capital in the futures and derivatives markets?

Let us begin at the beginning. You deposit money into your bank account. You have worked hard this week, avoided spending your entire paycheck, and are rightly proud that your care and prudence have enabled you to put a bit away for the proverbial -- but all too inevitable -- rainy day. Or, you have deposited your social security check, your pension check, your dividend check, your rental income payment, or whatever.

Those of you who are regular readers of this blog may remember our assessment and forecast for the commercial real estate market some time ago. We noted that a bear market in this asset class had been signalled quite some time ago, when two of the most astute real estate investors in American unloaded key properties at a time when prices were still climbing and bullishness remained rampant. We refer here to Sam Zell, the veteran real estate investor of remarkable prescience, and the Metropolitan Life Insurance Company, which disposed of two vast apartment complexes in Manhattan which it had owned since they were built in 1946. (The MetLife sale netted the insurance giant a tidy $5 billion). Our view was a distinct minority when we uttered it, shortly after the inception of this blog. At the time, financial magazines, talk shows, and the media generally were emblazoning their publications and shows with stories of the fortunes that had been made and were yet to be made in the invincible realm of commercial real estate.

This morning, a story on Bloomberg quotes various players in the commercial real estate business, and we would like to offer you a sample:

--"The market is locked up right now because there's a huge overhang of leveraged assets of every type..."

It is interesting to note the rising chorus of criticism of the FED's dramatic policy change. This places us in the unfamiliar position of having to defend our not-so-illustrious central bank.

The criticsm, which originates from the dierhard inflation-phobes, is now spreading rapidly to the keepers of the flame of monetary orthodoxy. These include important voices in the financial, economics, and media establishment. The party line is that the FED's big rate cut, and, horrors, the prospect of further rate cuts, raise the specter of INFLATION. Nor is this all. According to the inflation-phobic camp, we are entering a period of stagflation, similar to the 1970s. This land of horrors was characterized by a wretched economy, rampaging inflation, and a FED which, until the advent of Paul Volcker, could not print up currency fast enough. The FED "accomodated," then "monetized" the inflation, with support from the supposedly conservative Republican Administration in Washington.

Well folks, there is nothing quite like watching the fear among "policymakers" morph into panic in AN ELECTION YEAR as the stock market tanks and recessionary signals intensify to the point where even the most wilfully obtuse -- ie., the FED -- can no longer deny them.

Normally, as election time approaches, the Administration gets on the ball a lot faster than has been the case this time around. We attribute this slow-motion awakening to the President's preoccupation with national security and foreign policy matters. For this he can hardly be faulted. It is the responsibility of his economic team to warn him, in no uncertain terms, when economic turmoil impends. Our guess is that his team, while performing a lot better than the bury-thy-head-in-the-sand FEDERAL RESERVE allowed itself to be lulled by FED reassurances and wishful thinking to misperceive the gravity of the crisis in the banking system and the promise this held for a serious credit contraction. Our impression is that the Treasury Secretary has been alert from the gitgo, given his prior private sector experience. As for other policymakers and the bureaucracy, well.....

The new "bits and pieces" (see our original analysis, "Bailout By Bits and Pieces")consist of these:
--A dramatic, intermeeting, 75 basis point FED FUNDS cut;
--Rapid movement toward enactment of a tax rebate;

Reassuring words, joined for a change by reassuring actions, have been flowing rapidly over the last several days. While we are not saying that this is a centrally coordinated campaign, we are not saying it is not, either. It seems a trifle curious that the dramatic 75 basis point intermeeting FED rate cut, the accelerated movement toward enactment of a fiscal stimulus program, reported efforts to bail out -- yes, they are now, finally,admitting what they have to do -- quasi-insolvent municipal bond insurance firms have occurred rather simultaneously. We also note new issuances of preferred stock by major banks desperate to avoid insolvency, and new capital infusions from "sovereign" wealth funds.

What, we wonder, has catalyzed this wondrous confluence? Could it have been the dramatic fall in stock prices over the past week-and-a-half, which seemed to portend a true collapse a couple of days ago? Well...what do you think?