Finance and Credit Professional

The question on every investor's mind is: are we experiencing a mid-expansion slowdown or are we on the cusp of a recession? Even a recession would be just a bump in the road when compared to the damage to the economy, and the value of our investments, which would be brought about by a decline in the value of our homes or the huge US trade deficit.

Given the run up in housing prices, a 10% correction is not out of the question but it could put the economy into a tailspin. Why? Homeowners have been taking out the increase in the value of their homes through home equity loans and/or refinancing with higher principal balances.

If, for example, a homeowner had 20% equity in her home, but the value of the house fell by 10%, 50% of her equity would be wiped out. (Don't believe it? Run the numbers. This is the downside of leverage.)

A downturn in the housing market could exacerbate a decline in home prices. New homes construction has slowed, there's a backlog of houses and condos purchased by speculators to be worked off, mortgage rates could go higher, and mortgage terms are getting tighter as a result of the sub-prime debacle.

Why would mortgage rates go higher since the Fed is cutting rates, you ask? The answer is that many mortgages, including adjustable rate mortgages, are priced off of LIBOR, a London Sightseeing Passes" rel="nofollow" target="_blank">London-based rate.

Interest rates in Europe and elsewhere outside of the US are going up (and US interest rates could go higher, as discussed below). The result of a decline in housing prices and/or increasing mortgage rates will be a reduction in consumer spending that could plunge the US economy into a recession.

The annual US trade deficit has ballooned from approximately $100 billion in 1997 to an estimated $800 billion in 2007. What does the world do with all those excess dollars? It invests some back in the US stock market, buys American companies, real estate, and US Treasury securities.

Foreigners buying US Treasuries is good for us because it helps us finance our domestic budget deficits. The 2007 deficit is estimated to be in the $200 billion range.

Along with trade and fiscal deficits, the value of the dollar vis a vis other major currencies has been declining. Compared to the Euro (and a market basket of Western European currencies prior to the Euro), the dollar has depreciated in value by 38% over the past ten years.

You'll only hold a depreciating currency if the return on your investment exceeds its decline in value. In other words, the yield on US Treasuries has to compensate a European, for example, for holding a security whose principal value declines each year as the dollar declines, and provides a net return equal or greater than the return on Euro dominated government bonds.

The bigger our trade deficit, the bigger becomes the problem of recycling dollars. By the way, our single biggest import is oil and oil is priced in dollars. Thus, as the dollar declines in value, the price of oil will increase, adding to our trade deficit (and inflation).

A vicious circle if there ever was one. Will the world keep accepting US dollars? Probably, but at a price. Foreigners will demand higher interest rates on US Treasuries to compensate them for the dollar risk. This will have a ripple effect through our economy, driving up the cost of corporate borrowing, home mortgages, and causing a decline in stock prices as returns adjust to higher interest rates.

The government lacks the tools to quickly address either a housing value or trade deficit problem. Lowering interest rates further to ease the homeowners/mortgage holders plight would increase the fiscal deficit and create inflationary pressures.

Let's hope for a soft landing here. The only cure for a trade deficit is further depreciation of the dollar, a likely scenario, and a solution to our dependence upon foreign energy, an unlikely scenario in the near term. Let's hope foreigners will be happy to hold more dollars at the current interest rates. But, it's just that - a hope.

A decline in housing values or a trade deficit-induced crisis could throw the US economy into a recession of the depth not seen since the 1970s. Interest rates would go higher, unusual in a recession, and the stock market could correct by 40%. Invest cautiously.

About The Author :

Bill Byrnes is co-founder of MUTUALdecision, top mutual fundsa, providing investors with data on the top mutual funds, and author of the MUTUALdecision Blog. He's been CEO, chairman and served on the board of directors of several public and private companies. He holds MBA and JD degrees and is a Chartered Financial Analyst with over 30 years experience in the investment industry.

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