Japan`s Nuclear Crisis Threatens a Financial Meltdown

The focus remains on Japan today. The Fukushima reactors are reported to have gone through another explosion earlier in the day, in addition to a fire breaking out in a storage area where the highly radioactive spent fuel rods of the past 20 years are being kept. The steel cover that isolates the reactor core is known to have cracked in one of the plants. In response, the company that operates the reactors is planning to pour water on the spent fuel depots from helicopters over the next days in the latest of its desperate and unconventional actions. 

Although still in tolerable ranges, measurements in regions as far away as the capital have begun to show elevated levels of radioactive dust. Residents of the area surrounding the reactors have been advised to stay indoors, close the windows and wear masks when they have to go out. Those in the immediate vicinity are now being ordered to evacuate, in contrast to what was previously advice and recommendations to the same effect. Hoarding of foodstuff and necessities, energy and fuel shortages are being reported from around the country.

Japan`s natural disaster threatens to turn into a nuclear catastrophe, and the markets are not responding favorably. Commodities and stocks are selling off in a much anticipated phase of correction, while the the sharpest reactions continue to be experienced by Japanese markets. The Nikkei index has suffered its sharpest two-day fall since 1987, falling by 10% today alone, and Japan`s CDS yield has reached its highest ever level on record.

There are two major issues at the moment. How far reaching will the damage be on the Japanese psyche from the current crisis? And how much will the Japanese government borrow as it works to rebuild the economy? Will the world be willing to lend ever greater sums with the possibility that a significant proportion may not be paid back? Supply disruptions, the loss of Japanese demand, and market turmoil are serious issues, but their effects would be temporary if the Japanese people can get back to a degree of normalcy in a reasonable time. The nuclear crisis threatens to disrupt this process, and that is why the markets are reacting so nervously to the deteriorating situation.

Meanwhile, Bahrain in the Middle East has requested the deployment of foreign troops from the Gulf region yesterday in a bid to contain the unrest in the country as it threatens to transform into a shiite uprising. We are surprised to see a small Gulf nation call for the aid of its "brothers" so openly. The emirates and small kingdoms in the region are known to be highly suspicious of each other, and to prefer U.S. support over regional solidarity. So the common stance against a Shia minority may be regarded as a significant hint towards Iran that its intervention in the region is unwelcome, and may represent a hardening of attitudes in the Gulf Zone, with potential consequences for an eventual American-Israeli attack. It is interesting that the only regional power to condemn this action is Iran itself.

FOMC Remains Committed to QE, Moody`s Threatens a Future Downgrade

It is not surprising that the FOMC has decided not to restrict the scale of asset purchases so soon after they were initiated,  and yesterday`s dismal data on home prices certainly reinforces the notion that the Fed is not being too hasty in pumping liquidity into the system. The situation of the residential real estate market in the U.S. remains grim, and it is likely to get worse under the impact of judicial processes that could drag on for a long time. The Fed`s buying of Treasuries, if it does help to reduce mortgage rates, will certainly help alleviate the pressure on the economy. Yet this is far from being certain, because the market in question is enormous, and even if the bank temporarily manages to keep it afloat by engaging in quantitative easing, it is possible that a dosage of the medicine will need to be administered continuously in order to keep the sector afloat.

And that is the main problem, of course. The market is not so pessimistic that the Fed cannot engineer a jolt to growth for the near term, and its capability of boosting inflation somewhat for a limited time period is not a matter of great doubt. But there is no indication that such a short term program will deliver the necessary impetus to sustain a longer term reversal of course leading to elimination of the masses of the unemployed, and creating a self-sustaining momentum that can prevent asset price depreciation, and encourage Americans to spend. Although, on the basis of the demographic trends in the U.S., one may argue that the chances of such a plan succeeding over a considerable period of time are better than many would admit, the uncertainty surrounding the trajectory of U.S. public finances, and the USD during the implementation of this project depresses the enthusiasm of market participants.

The threat of the Moody`s rating agency, that it may place the U.S. on negative outlook if the present policy stance is maintained was not heeded by the markets today, and  the CDS market was mostly bullish, as traders seem to have some confidence in the notion that the Fed`s easing scheme will eventually contribute to an improvement in the economic situation. While there is no sign yet that the market is planning to abandon the U.S. government at any time soon, there are events that can make the market give up on U.S. assets. The degree to which the democratic process is effective in the U.S., the extent to which the best opinions are freely propagated to the public, will determine whether we`ll become witnesses to such events in the near future. The results of the November elections do not look discouraging in this respect.

Ultimately, the outcome for the public debt of the U.S. and the dollar is dependent on the outcome for the rest of the world. Those who espouse an overly pessimistic point of view on the U.S. economy are failing to place the country in a global context within a wider analytical framework. While it is true that the U.S. management monetary and fiscal policy is too adventurous and extreme in many ways, there is hardly a nation in the world that cannot be made subject to similar criticisms with a little bit of effort. Due to the increase in the velocity of money on a global scale over the past two decades, governments are unable to respond in a timely and effective manner to challenges created by capital flows. This is as true fo the Fed and the U.S. as it is for China, Brazil, the E.U. or any group of nations that is operating a sufficiently liberal economic system. The challenge is to the existing system, and not to any nation. With all its handicaps, the U.S. still enjoys a favorable status as it  has the unique advantage of possessing a powerful reserve currency that almost no one wants to depreciate, enjoys a well-established and healthy system of alliances, and dominates economic and political institutions around the world. Its media channels enjoy almost uncontested supremacy in the world, which contributes to the maintenance of a reasonable positive image. It is beyond doubt that Americans possess the means to destroy all these by foolish choices over the next years, but the background for the dollar-death scenario that people continue to speculate about is a remote possibility for now.